Tim Baikie's Capital Markets Update

SEC CTOs crowdsourced (or is it crowdsoused?) beer company offering

2011-06-14T12:33:00.000-07:00

The SEC recently issued a cease and desist order against two advertising executives in the first enforcement action targeting the use of social media to offer securities.

Michael Migliozzi II and Brian William Flatow wanted to acquire the Pabst Brewing Company, but didn't have the $300 million they figured would be required. They created a Facebook page and sent Twitter messages directing potential investors to BuyaBeerCompany.com (it's been shut down, so I can't provide a hyperlink).

In the first stage, the two sought pledges and required that pledgors only supply an e-mail address, first name, last name, and pledge amount. If they received $300 million in pledges, the second stage would consist of collecting the pledges and purchasing Pabst. Initially, website visitors were asked to commit to pledging a minimum amount and to provide their name and e-mail address. If at least $300 million was pledged, each investor would receive a "crowdsource certificate of ownership" and beer worth the amount invested.

By February 2010, more than $200 million had been pledged by more than five million people. No money was actually collected.

Migliozzi and Flatow did not register their offering with the SEC, as required under section 5 of the Securities Act of 1933. The SEC release is silent on whether offering beer violated the act, but that would be stretching the definition of "security."

This is becoming more of an issue. I frequently see postings on LinkedIn soliciting investments. Not only is there a problem with failing to comply with local securities laws, there is the danger that almost any securities commission could consider the securities to be offered for sale in their jurisdiction because of the global reach of the networks. At most, companies seeking to use social media to raise capital should simply state that they are looking to engage a registered dealer to assist them to sell securities in X jurisdiction and say nothing more.

SCOTUS clarifies materiality standard for corporate disclosure

2011-05-10T12:43:00.000-07:00

The recent US Supreme Court decision in Matrixx Initiatives, Inc. v. Siracusano clarifies the materiality standard for corporate disclosure, and will be relevant to Canadian issuers.

The case was an appeal of a motion to dismiss a securities fraud class action on the basis that the alleged misleading statements concerning Matrixx's leading cold remedy were not material. The District Court granted the motion to dismiss and was overturned by the Ninth Circuit Court of Appeal.

As the case concerned a motion to dismiss before trial, the court assumed that the facts alleged in the plaintiff's pleadings were true.

Background

Matrixx is a manufacturer of over-the-counter pharmaceuticals. One of these, Zicam Cold Remedy, accounted for about 70% of Matrixx's sales. The active ingredient in Zicam was zinc gluconate.

In 1999, Matrixx became aware of a possible link between Zicam and a loss of the sense of smell for users. In 2002, Matrixx's vice president for research and development received a number of complaints about a loss of sense of smell and was given abstracts of studies done in the 1930s and 1980s confirming "zinc's toxicity." Matrixx had done no studies of its own. In 2003, Matrixx learned that two doctors were planning to present findings about Zicam at a meeting of the American Rhinologic Society and warned them that they did not have permission to use Matrixx's or Zicam's names in their presentation. The doctors deleted the references.

One month after the doctors' presentation, the first of four class action lawsuits claiming Zicam caused a loss of smell were filed.

In October 2003, after the presentation, Matrixx issued a statement that Zicam "was poised for growth" and the company had "very strong momentum" with revenues increasing by 50% and earnings per share increasing by 25-30%.

In November 2003 Matrixx filed a Form 10-Q stating that product liability claims may result in a material adverse effect, whether or not proven valid. The form did not disclose that litigation had been commenced.

In January, 2004, Matrixx revised its revenue and earnings targets upward. On January 30, news reports stated that the Food and Drug Administration was looking into complaints about Zicam. The stock fell from $13.55 to $11.97 on the news. Matrixx issued a press release denying a link between its product and a loss of sense of smell. The stock rebounded, but fell again after a Good Morning America broadcast highlighted the issue and noted that four class actions had been launched. A new class action, this time on behalf of purchasers of Matrixx stock, followed.

The basis for the motion to dismiss

Matrixx argued that the plaintiffs had not alleged a "statistically significant correlation" between the use of Zicam and loss of smell to make a failure to publicly disclose the complaints or the earlier studies a material omission. They also argued that the plaintiffs had not stated with particularity facts giving rise to a strong inference of scienter (an intent to deceive, manipulate or defraud), which is a requirement in securities fraud litigation.

The court decision

In a unanimous opinion delivered by Justice Sotomayor (as far as I'm aware, her first) the court upheld the Ninth Circuit decision.

Sotomayor, J. noted that the test for materiality is whether there is a substantial likelihood that a reasonable investor would consider disclosure of a fact to significantly alter the "total mix" of available information. Matrixx was proposing a bright-line test of statistical significance that would "artificially exclude" information that would be significant to trading decisions. Both medical professionals and the FDA consider evidence of causation that isn't statistically significant, and it is reasonable to assume investors would as well.

The court noted that its decision is not a requirement to disclose all adverse drug effects, but ones that reasonable investors would consider to alter the total mix of information must be disclosed. The mere existence of adverse effect reports is not sufficient to support a securities fraud claim. More is required, but the reports do not have to be statistically significant. In this case, consumers would likely be wary of Zantac as the risk of losing the sense of smell outweighed any benefit from the product, especially given the number of cold remedies on the market.

With respect to scienter, the court noted that Matrixx had dismissed "out of hand" findings of a link between Zicam and loss of smell despite having done no studies of its own. It had no basis for making such a claim.

Implications for Canadian companies

The test of materiality in Quebec is more or less the same as in the United States. In other provinces, the test is whether disclosure of the information would reasonably be foreseen to have a significant effect on the market price or value of securities. In most cases, including this one, the result would be the same. There is no bright line. Materiality must be assessed on a case-by-case basis. As is the case in the US, the mere existence of adverse reaction reports will not give rise to an obligation to disclose. But the number and context of such reports may give rise to an obligation to disclose well before they reach a statistically significant number.

Feds 0-2 on constitutionality of draft securities law

2011-04-05T07:50:00.000-07:00

On the heels of the recent Alberta appellate decision striking down the proposed federal securities act, which I blogged about last month, the Quebec Court of appeal has released its own decision finding that the proposed law is unconstitutional. A link to the decision, which is only in French, is provided here.

The Quebec court generally agrees with the Alberta court's analysis. The ruling is not unanimous - there are two concurring majority opinions and one dissenting opinion finding the proposal is constitutionally valid. All of the judges agreed that the proposed law should not be given the usual presumption of constitutional validity because it was merely a proposal, not a law that had gone through the parliamentary requirements for readings, debates and committee hearings.

The Majority Decision

The majority believed that the federal law was concerned with regulation of an industry, namely the regulation of participants in the securities markets. The courts have consistently upheld the validity of provincial regulation in this field.

The majority then examined the "double aspect" doctrine, where federal and provincial legislation regulating the same conduct may have different purposes, each of which is valid. For example, a federal law prohibiting drunk driving has been held valid as an exercise of the criminal law power, while a provincial law imposing penalties for drunk driving has been held valid as a necessary aspect of regulation of local highways. The majority found that the proposed legislation regulated the same activities as the provincial legislation for the same purpose: protection of investors. They found only a single aspect that failed to meet the General Motors test for determining whether a matter could be under the federal power to regulate trade and commerce described in my previous post.

The majority held that the proposal concerned regulation of a single industry (the securities industry) rather than of trade and commerce in general, and the provinces were perfectly capable of regulating the field. The court contrasted the subject matter with other federal commercial legislation. While entities regulated by the securities act are in the securities industry, entities regulated by the competition act are not in the "competition industry," nor are entities regulated by trademark law in the "trademark industry." The fact that the securities industry has extra-provincial or international aspects does not change its fundamental characteristic. The court cited previous caselaw that held that the fact that the federal government has entered into a treaty governing a particular matter does not give it jurisdiction to pass implementing legislation if the subject matter is properly of provincial concern.

The Dissent

Mr. Justice Pierre Dalphond wrote a dissenting opinion upholding the proposed legislation as valid. He began by noting that the terms "capital markets" (marchés des capitaux), "securities market" (marché des valeurs mobilières), "trading/dealing in securities" (commerce des valeurs mobilières) and "securities industry" (industrie/secteur des valeurs mobilières) should not be considered synonyms.

Dalphond, J. agreed with the majority that the federal proposal should not be presumed to be constitutional. He disagreed with the majority's holding that the proposal could not be valid under the double aspect doctrine as it duplicated provincial law. It is possible for Parliament and the provincial legislatures to pass identical legislation provided the subject matter falls within each body's sphere of competence.

Dalphond, J. then gave an overview of the history of the capital markets in Canada and the relevant court decisions. This was particularly pleasing to a history buff like me. He noted that while a number of Privy Council decisions upheld the power of the provinces to regulate brokers and securities trading in the province, none of them were precedent establishing the ability of the provinces to regulate the capital markets as a whole.

Dalphond, J. held that the Canadian capital market is integrated and national in scope, with stock exchanges and self-regulatory organizations operating on a national level, characterized by transactions that are mostly extraprovincial in nature. More than 95% of issuers, including smaller ones, raise capital in more than one province.

This national market is more than simply a collection of provincial capital markets. It is also unlike the insurance industry, where each policy is an isolated contract and not part of a greater whole.

Because the capital market is national, no one commission can fully regulate it. In particular, only the OSC regulates the TSX, which is a national institution. Only a national commission can simultaneously regulate all components of the market.

The dissent mirrors more or less my own thinking on this topic, and I will be finalizing a paper shortly. It remains to be seen which side the Supreme Court of Canada will fall on when the case is argued later this week.

Musings on the Alberta decision on federal securities legislation

2011-03-14T12:24:00.000-07:00

Last week, the Alberta Court of Appeal issued a ruling that the federal government did not have the power under the Constitution Act, 1867 to adopt federal securities legislation. The ruling was in response to a reference by the Alberta government challenging the federal legislation.

The court began by noting that securities law is one of the four pillars of financial regulation (the others being banking, insurance and trust companies) and that, of the four, only banking is regulated federally and only then because of an express head of power in the Constitution. The court also noted that provincial jurisdiction over securities law has traditionally been upheld as an exercise of the "property and civil rights" power.

The federal government argued that it had the authority under the "general" trade and commerce power first set out by the Privy Council in 1881 in Citizens Insurance Co. of Canada v. Parsons. That case also held that the federal government could have jurisdiction over international and interprovincial trade, but the government did not assert these latter aspects as the proposed legislation would govern transactions within a province.

The general trade and commerce power was fleshed out by the Supreme Court in 1989 in General Motors of Canada Ltd. v. City National Leasing. That case set out a non-exclusive, five-point test for determining whether the federal government had a valid basis for legislating:

1. The legislation must be part of a general regulatory scheme;
2. The legislation must be concerned with trade as a whole, not a particular industry;
3. The legislation must establish a scheme subject to continuing oversight by a regulatory authority;
4. The provinces jointly or severally do not have the constitutional authority to enact similar legislation; and
5. The failure of one or more provinces to enact legislation would thwart the purpose of the legislation in other parts of the country.

The court conceded that the legislation was part of a regulatory scheme with continuing oversight by a regulatory authority, but found the legislation failed to meet the other tests. It did not consider the act to regulate "trade" but "a particular industry, namely that which raises money from the general public." It also found that the provinces do have the constitutional authority to enact securities legislation, and that the fact that the federal act will not initially apply nationally (as it allows provinces to opt in to the federal regime) means the fifth criterion is not met.

The court held that it is not enough that federal legislation be desirable or that it would impose uniform regulation across the country. If that were sufficient, any federal legislation would be valid and the property and civil rights power would have little meaning. It stated that the same argument could be used to justify federal regulation of insurance, which the courts have repeatedly held is a matter for exclusive provincial jurisdiction.

Although the federal government did not try to justify the legislation as an attempt to regulate international or interprovincial trade, the court held that securities legislation is at its core the regulation of raising funds from members of the general public, that securities are a form of property and that trading in that property is a series of contractual and property arrangements, none of which involves the cross-border movement of property. The court also noted that Canadian companies have relied upon access to international capital markets since Confederation.

A Critique

In my view, the court has taken an overly restrictive view of the nature of securities legislation. While it is true that the first provincial acts governed the sales of securities to local investors, the industry (and the scope of regulation) has grown substantially since then, to encompass regulation of issuers (not only of disclosure, but shareholder rights and corporate governance issuers), brokers, stock exchanges, self-regulatory organizations and clearing corporations to name but a few. It is much more than raising funds.

I think it would be better to think of the pith and substance (to use a term beloved of constitutional lawyers) of securities regulation not as regulation of capital raising or sales practices but as regulation of the capital markets as a whole. I believe that market participants, including foreign investors, see a Canadian capital market, not separate Ontario and Alberta ones, and that a failure by any one province to regulate its capital markets properly will damage the reputation of the capital markets as a whole. An argument can certainly be made that effective regulation of national capital markets can only be done at the federal level. This was the rationale in the General Motors case, which held that competition could only be effectively regulated at the national level.

A secondary matter is that much of securities legislation today has an extraprovincial effect. This is particularly true for Ontario, where a company that has raised money in the province or listed on the Toronto Stock Exchange becomes a "reporting issuer" subject to ongoing regulation by the OSC. Most of the TSX/S&P Index issuers were incorporated outside the province, meaning that OSC rules have a broad impact on corporate activity that may only marginally touch upon the province.

I also don't believe that trading does not involve cross-border elements. While it is true that a sale by a Victoria Investor to a Miami Investor on the TSX involves a number of discrete steps, it is equally true that the exchange and the clearing corporation are acting on a national basis. Furthermore, the fact that the trade occurred on the TSX may be happenstance, as an order may have been required to be routed there to meet "best price" obligations.

The court states that the argument for federal regulation could be applied to insurance, but I don't think so. Although insurance companies operate nationally, it is fundamentally a series of bilateral contracts. If I take out an insurance policy (or a mortgage with a trust company), that is the beginning and the end of the transaction. There is no interprovincial aspect to my dealings(even if my insurer lays off its risk to a foreign re-insurer), which there easily could be in a trade in securities.

The argument that the legislation fails to meet the final test because of the opt in feature ignores the fact that the government is attempting to introduce the legislation in the most politically palatable manner, and insisting that the scope be national from the beginning is, to quote Voltaire, an example of the perfect being the enemy of the good. It would certainly put the cat among the pigeons if the court's ruling is interpreted to mean that the federal government cannot act in an incremental manner, but has the authority to occupy the whole field in one fell swoop.

What the Court Got Right

The Court quite properly didn't get into an analysis of whether federal regulation would be better or more desirable. These are political, not legal, arguments. If the federal government has the power to regulate, it can, no matter how disastrous the outcome may be. Similarly if it does not, it cannot no matter how inefficient and fragmented the markets may be under provincial jurisdiction.

The court also rebuked the federal government for arguing that federal regulation was necessary to address systemic risk, noting that there were no prudential provisions in the draft federal act dealing with systemic risk.

Interprovincial Trade

I'm somewhat perplexed that the federal government isn't attempting to justify the legislation under the interprovincial trade test. While it's true that the draft legislation regulates transactions within a province, limiting the scope of the federal power to interprovincial matters would still allow federal regulation of the vast bulk of securities law matters. In this respect, it would be similar to the United States, where state regulators still have authority over intrastate transactions. It is also the approach that the federal government took when adopting the Grain Futures Act in 1939, allowing it to regulate trading on the Winnipeg Commodity Exchange. It's interesting how few people in this industry realize that the Winnipeg exchange was regulated only at the federal level until 2000, when Manitoba enacted its Commodity Futures Act and the Manitoba Securities Commission assumed oversight authority.

Random Thoughts on Regulating the Merged TMX-LSE

2011-02-14T09:27:00.000-08:00

It's not every day I get quoted in the Financial Post. Since I haven't posted for a while, I thought this was the perfect excuse to get back in the swim of things.

My views were a little confused in the article. Whether this was due to incoherence on my part or editorial tweaking I don't know, but I'd like to set down a few thoughts.

All I know about the proposed merger is what I've read in the press, which is to say I don't know all that much. At its most basic, this could end up as a number of stand-alone stock exchanges with common ownership. Although this raises fewer regulatory concerns, it means that the merger will be a non-event for investors, issuers and other market participants.

There is, of course, no international body to regulate global markets, so they have continued to be regulated at the local level. In this regard, the current approach of the Canadian Securities Administrators serves as a model for international regulation. The TMX Group, headquartered in Toronto, runs four exchanges: The Toronto Stock Exchange (TSX), the Montreal Exchange (ME), the TSX Venture Exchange (TSX VE) and the Natural Gas Exchange (NGX). It also owns a majority interest in the Boston Options Exchange (BOX).

The exchanges are overseen by the provincial securities commissions on a lead regulator model, where only one commission effectively regulates each exchange: Ontario for the TSX, Quebec for the ME and Alberta for the NGX. The TSX VE has both B.C. and Alberta as lead regulators, but they have divided their oversight responsibilities so there is no overlap. BOX is overseen by the SEC.

There is no reason why the same model can't work for the merged entity, with the TSX continuing to be regulated by the OSC, the LSE by the FSA in London and the Bolsa Italiana by the Italian regulator. If all of the various commission insist on having a say in regulating each exchange that is part of the group, it would likely be unworkable, particularly as the Canadian stock exchanges have a great self-regulatory role (either directly or through IIROC) than their European counterparts.

Of course, there will need to be co-ordination if the merged entity wants to harmonize rules across all markets.

The FP article also talked about a college of regulators and suggested that I see a role for IOSCO. This isn't the case. What I said was that it is possible for regulators to specialize to take advantage of local expertise. For example, in Canada, there is expertise for regulation of oil & gas issuers in Alberta and derivatives in Quebec. This does not mean that there will be one regulator of a particular product or issuer.

Take oil & gas. The disclosure standards in National Instrument 51-101 for oil & gas activities were probably largely developed by staff of the Alberta Securities Commission (I don't know this for a fact, but it is a logical assumption). They are national rules, but are not administered only by the ASC. They are in effect in Ontario because the OSC has adopted them as a local rule, and any prospectus by an oil & gas issuer that is cleared in Ontario will have its disclosure reviewed by the OSC. While it is possible a similar recognition of expertise could happen at the international level, I don't see a global regulator anytime soon.

Box Office Futures Make Debut

2010-12-05T14:11:00.000-08:00

A recent trivia item on the Internet Movie Database noted that the movie Takers was the first film to have its box office as the underlying interest of futures contracts. Intrigued, I decided to dig a little deeper.

Trading of Takers futures was approved by the Commodity Futures Trading Commission after a public meeting held to consider the issues arising from this unique product.

In March of this year, Trend Exchange (formerly Media Derivatives Inc.) requested CFTC approval to trade Opening Weekend Motion Picture Revenue collard futures and binary option contracts on Takers. Section 5c(c)(3) of the Commodity Exchange Act requires the CFTC to accept a contract unless the commission finds that the contract violates the Act. In its order approving the contracts, the CFTC found:

Box office receipts are "commodities" for the purpose of futures trading, which for this purpose includes non-price-based measures of an economic activity, commercial activity or environmental event. The order lists many pages of contracts with similar economic underlying interests.
The cash settlement price is derived from revenue numbers collected by Rentrak Corporation, a third-party data aggregator that has no direct monetary interest in any motion picture, and is disseminated throughout the industry. The underlying interest is therefore not subject to manipulation.
The Commission made the exchange to adopt a rule requiring those who control a film’s marketing budget, release date or opening screen numbers and who hold at least 1,000 contracts to provide information to the exchange regarding decisions in these areas. The intention is to ensure they do not take actions such as delaying a release date or increasing the number of opening screens to benefit their futures holdings.
The contracts provide a reasonable means for managing the risks associated with box office returns.

Big Changes Proposed to Ontario Securities Act

2010-11-25T08:50:00.000-08:00

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.

Derivatives

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.

CSA/IIROC Position Paper on Dark Markets Released

2010-11-19T09:45:00.000-08:00

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:

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.
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).
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.

Share Structure Concerns in IPOs

2010-11-03T11:36:00.000-07:00

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.

IIROC reports on new product due diligence, principal protected notes

2010-09-22T13:08:00.000-07:00

IIROC has issued two notices on their new product due diligence regulatory review and their principal protected notes compliance review.

New products
With respect to new products, IIROC notes that it is part of a Dealer Member's gatekeeper responsibilities to review and monitor new products before they are offered to clients. Otherwise, the dealer cannot determine suitability.

IIROC's examined 14 dealers. Two did not have written new product due diligence policies and many of the others were materially deficient. Some of the common deficiencies identified were:

No clear definition of "new product" that would trigger a review to determine retail and institutional suitability.
No appropriate level of internal review. At a minimum, the review should include the Chief Compliance Officer and the firm's relevant "subject matter experts" who have knowledge of the product.
Lack of a framework to ensure that the subject matter experts ask the right questions about the product and receive satisfactory answers.
Lack of consideration of conflicts of interest (such as a non-arm's length product) and how they should be addressed.
No analysis of proficiency issues arising that must be addressed to ensure advisors and their supervisors fully understand the product.
No process to monitor and follow up on customer complaints concerning the product.
No controls to ensure that all new products are reviewed. The notice states that this should include new products that come into the firm by a transfer or client deposit in addition to products identified by advisors

Principal protected notes

IIROC's review of PPN sales practices was a result of the freezing of the market for asset backed commercial paper in 2008. The review found the following:

Distribution of the required disclosure to clients was inconsistent. Although dealers stated this was the PPN issuer's responsibility, many dealers did not have a due diligence procedure to ensure that the issuer in fact sent the disclosure.
Dealers were unable to produce evidence that their clients received notice of monetization (i.e. that a protection event had been triggered affecting the product) as they did not have an agreement with the issuer whereby the issuer would send the notice.
Key information about products was missing from marketing material.
There was evidence that the many registered representatives did not understand the risks inherent in the products, particularly for elderly investors holding an investment that might be locked in for as long as ten years. There was no uniformity of training of RRs.
Client statements did not contain enough information to allow clients to identify their security holdings and monitor their investment.

Securities Regulation in Federal States - Help Needed!

2010-08-26T11:43:00.000-07:00

I am currently doing some research into the constitutionality of the proposed Canadian federal securities act, and would like to compare our situation with other federal states. I have covered off (I think) Brazil, Germany, Switzerland and the U.S., but would appreciate it if anyone could provide me with information about other countries, In particular, I would like to know if the constitutional basis for regulation at the federal (or state, or both) level. Any assistance will be appreciated and acknowledged.

IOSCO's Principles for Direct Electronic Access to Markets

2010-08-19T10:31:00.000-07:00

IOSCO published its final report on direct electronic access to markets in August. A consultation report on the subject was released in February, 2009. The report may be used by Canadian securities commissions in any examination of issues arising out of direct access.

The report identifies three forms of direct access:

Automated order routing through an intermediary's infrastructure, where the direct access customer's order is passed on automatically to a market for booking or execution using the intermediary's member identifier;
Sponsored access, where the customer can send orders directly to a marketplace without using the intermediary's infrastructure but using the intermediary's member identifier; and
Direct access, where a customer enters orders on a marketplace directly using its own (or the market's) infrastructure using an identifier for that customer. These market participants must enter into a clearing agreement with a member of the market's clearing agency.

The report notes that direct access arrangements pose potentially substantial risk to clearing firms and the market. It states that many markets are concerned that they do not have enforcement jurisdiction over their members' clients, but the report points out that the statutory regulator will have jurisdictions over all participants in its capital markets.

Intermediaries tend to mitigate their direct access risk in three ways:

Knowing their customer (e.g. examining regulatory history, creditworthiness);
Pre-execution risk controls (identifying problems or anomalies before an order hits the market's trading system or before it is executed); and
Post-execution controls.

Pre-execution controls are not as effective or non-existent for sponsored access clients.

The report sets out 8 principles applicable to direct access trading arrangements, grouped in three main categories: pre-conditions for direct access, information flow and adequate systems and controls. These principles are:

Minimum Customer Standards: establishing the customer's creditworthiness, knowledge of applicable market rules and ability to comply and ability to correctly use the order entry system.
Agreement: The intermediary should have a binding agreement with each customer, tailored to the services to be performed. Marketplaces should consider whether they should have agreements with direct access customers.
Rules should clearly spell out that the intermediary is responsible for trades by its direct access customers.
Intermediaries should identify direct access customers to markets to assist in surveillance.
Markets should provide intermediaries with adequate real time information to enable the intermediaries to institutes effective monitoring and risk assessment controls.
Markets should have systems and controls designed to minimize market integrity concerns (e.g. disorderly trading) arising from direct access customers' activities.
Intermediaries should have appropriate controls, particularly on a pre-trade bases, to prevent direct access customers from exceeding position or credit limits.
Intermediaries and clearing firms should have operations and technical capabilities to manage risks arising from direct access.

CSA Releases Proposal to Regulate Credit Rating Agencies

2010-07-28T10:20:00.000-07:00

The Canadian Securities Administrators have released a draft of National Instrument 25-101 a proposal to regulate credit rating agencies whose ratings are used in places where credit ratings are referred to in securities legislation.

NI 25-101 is dependent on the enactment of legislation to give the various commissions jurisdiction to regulate the agencies. Legislation is already in place in British Columbia, Alberta and Quebec and is expected to come in to force concurrent with NI 25-101.

NI 25-101 is a voluntary framework for credit rating agencies that wish to become "designated credit rating organizations." An agency does not have to apply for designation, but if it does not, its ratings cannot be used to support, for example, an exemption from the prospectus requirements for a distribution of securities that have a minimum credit rating. NI 25-101 would replace the current regime of "approved" credit rating agencies in securities legislation.

An applicant to become a designated credit rating organization must file Form 25-101F1 with the applicable commissions. The disclosure in the form includes

whether the applicant makes its ratings generally accessible for free or for a fee,
the procedures and methodologies used by the applicant to determine credit ratings, including unsolicited ratings,
the applicant's code of conduct,
the applicant's policies and procedures for containment of non-public information and for identifying and managing conflicts of interest,
the number of credit analysts and supervisors and their qualifications,
the name of the compliance officer,
information concerning revenues from credit ratings, subscribers and licences to publish ratings, and
a list of the largest users of the rating service.

A designated credit rating organization must ensure compliance with the revised IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. An agency will be allowed to deviate from the Code provided it explains the reasons for the deviation and how it meets the objectives of the Code notwithstanding the deviation.

In addition, designated credit rating organizations must have policies and procedures to identify and manage conflicts of interest and to prevent the inappropriate use of non-public material information, including pending rating changes. The firm will not be permitted to issue a credit rating if a conflict of interest exists and must designate an officer as responsible for compliance with NI 25-101. The agency must also make prescribed filings with the commissions.

While it is expected that the enabling legislation would prohibit commissions from regulating the content of credit ratings or the methodologies used, this may not be the case in all jurisdictions. In addition, the proposal does not address whether the current exclusion of credit rating agencies from the provisions imposing civil liability for misrepresentations should be maintained.

The deadline for comments is October 25.

CSA consults on venture issuer regulation

2010-06-21T12:40:00.000-07:00

The Alberta, B.C., Manitoba, New Brunswick, Nova Scotia and Saskatchewan securities commissions have released a consultation paper on venture issuer regulation. The Ontario and Quebec commissions, while not fully participating in the consultation process, have urged their market participants to comment on the proposals. The comment period closes September 17.

The consultation paper contains the text of proposed rules, but these are for "conceptual purposes" only. Any rule changes resulting from the consultation process will be issued for comment in the normal course.

The paper notes that venture issuers (that is, issuers listed on the TSX Venture Exchange and the Canadian National Stock Exchange, or that trade over the counter in Canada or on international junior markets such as AIM on the London Stock Exchange) face particular compliance challenges given the complexity and breadth of modern securities regulation. It concludes that one size does not fit all and that a tailored approach to regulation of venture issuers is appropriate. Of course, whether this threshold assumption is valid is one of the questions asked.

The paper proposes that current exemptions for venture issuers and special rules tailored for venture issuers be contained in stand alone rules. To make the rules easier to understand, explanatory text will not be in a separate companion policy, but will be in short guidance notes contained within the body of the instrument.

Continuous Disclosure

The proposal will streamline disclosure obligations for venture issuers. The requirement to file first and third quarter financial statements will be removed. Instead, issuers will file an annual report that contains aspects of the current disclosure requirements for an annual information form (AIF), management's discussion and analysis (MD&A), and annual financials. It would be a mandatory document - today a venture issuer is not required to file an AIF unless it wants to use a short form prospectus or take advantage of a prospectus exemption that requires an up-to-date AIF. The MD&A will discuss objectives, targets and milestones, and progress against those targets, rather than annual information disclosure and a two-year summary of financial results.

Issuers would also be required to file a mid-year report including MD&A and financial statements for the six-month period, as well as updating any information in the annual report that has changed in the interim.

Venture issuers would not be required to file business acquisition reports but would file a report similar to a material change report. Confidential filings would not be permitted as they are today. The paper gives no explanation why, but perhaps the regulators are concerned about misuse of confidential filings to delay releasing bad news.

Information circulars would only be required to contain disclosure strictly necessary to allow a shareholder to understand the matters to be voted upon at the meeting. Other information, such as executive compensation and corporate governance disclosure, would be contained in the annual report and would not have to be included in the information circular unless the annual report had not been filed at the time the circular is filed.

Issuers will be able to use "notice and access" to electronically distribute material to shareholders rather than mail them.

Governance

The proposal contains several governance measures:

Directors and officers would have to act honestly and in good faith and to act with the care, diligence and skill of a prudent person acting for a venture issuer will be imposed. Although this is largely duplicative of corporate law, the proposal notes that some issuers are incorporated under legislation that does not contain these obligations and some venture issuers, such as trusts and partnerships, are not incorporated at all.
Boards of directors would have to have procedures to ensure they are made aware of, and have an opportunity to discuss, conflicts of interest between the board and management and any proposed related party transactions.
Companies would have to have procedures to deter illegal insider trading.
The CEO, CFO and two directors would have to sign a certificate filed with the annual and mid-year reports that the reports contain no misrepresentations and fairly disclose the information. They would also confirm that all of the directors and officers had confirmed their compliance with the proposed duty to act honestly and with the care and skill of a prudent person.
Audit committees would be required to have a majority of members who are not officers or employees of the issuer or its affiliates.

The provisions regarding the rights and responsibilities of directors and officers fall squarely under corporate law rather than securities law, and it is hard to see how the commissions have the authority to implement them. However, that is a matter for another post, another time.

Prospectuses

The main proposal with respect to prospectuses is to reduce the requirement for three years' prior financial statements to two.

Draft Federal Securities Act Released

2010-05-26T13:41:00.001-07:00

The proposed federal securities act is available at http://www.fin.gc.ca/drleg-apl/csa-lvm-eng.asp. It has been tabled in Parliament for information only as it will be referred immediately to the Supreme Court for a ruling on its constitutional validity.

I'll be commenting on it after I've had an opportunity to digest it.

British Columbia Introduces Framework for Regulating Credit Rating Agencies

2010-05-03T13:46:00.000-07:00

The B.C. Finance Statutes Amendment Act, 2010 contains provisions to amend the Securities Act to provide a framework to regulate credit rating agencies (CRAs). The Act has received Royal Assent, but the new provisions have not yet been proclaimed in force. The Act is as interesting for what is missing as for what it contains.

The Act provides the building blocks for a regulatory regime but does not require or even permit CRAs to be recognized. It contains provisions

preventing any person from representing that the Commission approves or endorses a CRA (amending s. 55 of the Act);
allowing the Commission to order a CRA to produce records (amending s. 141(2)), submit to a review of its practices and procedures or to change its practices and procedures (amending s. 161(7);
empowering the executive director to conduct a compliance review of a CRA (amending s. 141.1(1)) and the Commission to conduct an examination of a CRA's financial affairs (amending s. 153(1);
allowing the Commission to collect information from and share information with a CRA (amending s. 169(1)); and
allowing the Cabinet to enact regulations concerning CRAs (amending s. 183 - the Commission has a plenary power to enact rules regulating the securities industry other than certain categories reserved to the Cabinet under s. 184(4). That section is not being amended to preclude the Commission from enacting rules for CRAs.).

A more comprehensive regime for regulating CRAs is expected when new National Instrument 25-101 Designated Rating Agencies is released for comment, expected later this month.

The legislation does not contain an express prohibition on the Commission the substance of credit ratings or the procedures and methodologies by which credit ratings are determined, similar to the provisions of s.15E(c)(2) of the Securities Exchange Act of 1934. Perhaps the legislature was influenced by developments in the United States to require the SEC to do just that. The following is the provision from the House bill (H.R. 4173), the (1706 page!) Wall Street Reform and Consumer Protection Act of 2009:

[New] 15A(3) REVIEW OF INTERNAL PROCESSES FOR DETERMINING CREDIT RATINGS.—

(A) IN GENERAL.—The Commission shall examine credit ratings issued by, and the policies, procedures, and methodologies employed by, each nationally recognized statistical rating organization to review whether—

(i) the nationally recognized statistical rating organization has established and documented a system of internal controls, due diligence and implementation of methodologies for determining credit ratings, taking into consideration such factors as the Commission may prescribe by rule;

(ii) the nationally recognized statistical rating organization adheres to such system; and

(iii) the public disclosures of the nationally recognized statistical rating organization required under this section about its credit ratings, methodologies, and procedures are consistent with such system.

Moody's Less Than Stellar Governance

2010-04-01T14:26:00.001-07:00

This is an interesting article on Moody's cororpate governance (or lack thereof) during the financial crisis:

http://insurancenewsnet.com/article.aspx?id=176563&type=newswires

IIROC issues draft guidance on locked and crossed markets

2010-03-27T13:49:00.000-07:00

IIROC has issued a request for comments on proposed guidance on locked and crossed markets. A market is "locked" when a bid is entered on one marketplace at the same price as an offer on another marketplace, or an offer is entered at the same price as a bid. A market is "crossed" when a bid is entered at a higher price than an offer on another market, or an offer at a lower price than a bid.

Markets may be locked or crossed for any number of reasons, including different latencies in various order entry and market data systems (such that the person entering the order doesn't see the order in another market entered a split second earlier). However, one incentive to lock or cross a market is rebate arbitrage, where a trader will enter a passive order hoping to entice the order on the other side of the lock or cross to trade with it. The strategy is used to take advantage of the practice of many markets to pay a fee to liquidity providers (passive orders).

Intentionally locking or crossing a market is a violation of section 6.2 of National Instrument 23-101.

The draft guidance provides examples of situations IIROC considers acceptable and unacceptable. IIROC does not view a lock or crossed market to be intentional if

race conditions existed where orders are entered on different markets at essentially the same time,
the lock or cross is due to the latency of the system(s) used,
there was a malfunction or material delay in the system(s) used, or
a "bypass" order (an order to take out the visible orders at better prices on other markets when entering a cross outside the national best bid and offer) bypasses undisclosed liquidity at better prices that is exposed immediately after the entry of the order.

A market may be locked (but not crossed) if the person entering the order is required to enter it on a particular market. For example, if a security is subject to resale restrictions under the SEC's Regulation S, it can only be resold in a "designated offshore securities market" under that rule. Currently only the TSX, the TSX Venture, CNSX and Pure Trading are designated, which means that an order could be entered on one of those markets that locks with a non-designated markets. Although the notice is silent on the point, presumably an order could not be entered on Pure Trading that locks with the TSX.

The notice also clarifies that a person who has properly entered an order on a market that subsequently becomes locked because of an order entered on another market is not obliged to remove the order and enter it on the other market. It further clarifies that locking or crossing a market for the purpose of rebate arbitrage is not permitted.

The guidance is open for comment until May 25, 2010. Comments should be directed to James Twiss, Vice President, Market Regulation Policy.

IIROC publishes first installment of plain language rule rewrite for comment

2010-03-27T13:15:00.000-07:00

IIROC has issued a request for comments on proposed new rules 3100 - Business Conduct and 3200 - Client Accounts. The rules are part of an overall project to rewrite all IIROC rules, by-laws and policies in plain language and to reorder and reorganize them in a more coherent manner (full disclosure: I was retained to work on parts of this project).

The project also had the following goals:

to eliminate unnecessary or obsolete provisions
to clarify IIROC's expectation of its members
to conform the rules to actual practice
to ensure consistency with other rules and securities legislation, and
to clarify those provisions that are mandatory (which are drafted as rules) from those that are suggestive (which are drafted as guidance notes).

In addition to the dealer rules, the universal market integrity rules will be included in this project.

As part of the rule rewrite project, a number of rules were identified which require substantive changes.

The rules are being released in 8 tranches with a longer than normal comment period (90 days versus the usual 30), in order to ensure opportunity for review and comment. Any proposed substantive changes are noted in the request for comment. In the case of rules 3100 and 3200, there are a number of substantive changes that are outlined in the request for comments.

The comment period is open until June 27, 2010. Comments should be directed to Sherry Tabesh-Ndreka, Policy Counsel, Member Regulation Policy.

The Impossible Scheme - Hong Kong Court Finds Share Splitting Manipulative

2009-10-18T11:26:00.000-07:00

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.

L'Affaire Madoff I: A Night to Remember

2009-09-06T12:59:00.000-07:00

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

2009-09-06T12:25:00.000-07:00

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.

Quebec Appeal Court Cuts Norbourg Fraudster’s Jail Time

2009-08-30T14:51:00.000-07:00

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.

Background

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.

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

2009-08-26T08:02:00.000-07:00

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.

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

2009-08-24T14:29:00.000-07:00

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.

It Was a Dark and Stormy Night....

2009-07-27T07:12:00.000-07:00

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:

Before:

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.

After:

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.

Insider Twitting

2009-07-23T14:38:00.000-07:00

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.

OSC requires shareholder approval of acquisition

2009-01-28T12:30:00.000-08:00

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.

Background
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.

Analysis
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.

A federal securities commission on the horizon?

2009-01-19T10:31:00.000-08:00

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.

The Financial Crisis II: Everything Old is New Again

2008-12-15T12:11:00.000-08:00

The Pennsylvania family I mentioned in my last post can add to their accomplishments causing a constitutional crisis in Canada, nearly wiping out the North American auto industry and prompting a purportedly conservative U.S. government to effectively nationalize many companies. On the bright side, it seems they also caused Bernie Madoff's alleged record-breaking fraud to be exposed.

The crisis has also triggered regulatory responses. Some of these were taken from playbooks of yesteryear, such as imposing restrictions on short sales. Some were the opposite of actions taken in the past; the Glass-Steagall Act was passed in 1933 mandating the separation of banking functions so that customer deposits could not be put at risk by investment banking activities. This year, the remaining independent investment banks were allowed to become bank holding companies, shoring up their capital base in return for greater government prudential oversight.

The finger-pointing has already begun, with an unseemly rush by regulators to blame other regulators for the fallout. The Federal Reserve argues it didn't have the authority to prevent the collapse of Lehman Brothers, while the SEC argues its mandate is investor protection, not prudential regulation. It is clear that at least two significant gaps are in the regulatory regime. There are significant transactions taking place in a completely opaque, unregulated environment. To make matters worse, no single regulator could see the potential impact of these transactions on regulated entities.

The Overall Regime

How these will be addressed is far from certain, but I will venture a few predictions. The first is that the regulatory regime in the United States will be overhauled (there is less need of a comprehensive overhaul in Canada). Regulation of derivative trading has traditionally had a light touch (except for a ban on trading onion futures) on the basis that everyone in the market was a sophisticated player. Clearly, they are not sophisticated enough. Therefore, I predict that the coming year will see more comprehensive regulation of option, futures and insurance contracts, possibly with a requirement to clear all over-the-counter trades through a new central clearing house that would establish maximum risk parameters. There may be a merger of the SEC and the CFTC, but more effective would be a single prudential regulator overseeing the financial health of banks, broker dealers and insurance companies. This will be coupled with greater financial disclosure requirements and stringent requirements to stress test various potential scenarios regardless of their likelihood.

This will create a tension as prudential and traditional securities regulation will sometimes be at cross-purposes. If a bank is experiencing difficulty, a prudential regulator may want it kept quiet to avoid a run on the bank while it attempts to shore up its capital. A securities regulator would insist on immediate disclosure.

In Canada, the banks and brokerages are in much better condition, perhaps because of greater conservatism. That being said, the crisis should bolster the call for a single national regulator that will have jurisdiction over the entire brokerage industry.

The crisis should also provide a stimulus for harmonization of international bankruptcy rules regarding things such as set-off rights.

Other Regulatory Responses

I will state for the record that I am unconvinced that the restrictions on short selling are necessary. I have seen nothing that convinces me that short sales have exacerbated the downward spiral of the markets, and removing exemptions for market makers will only hinder their ability to smooth-out price swings. That being said, the position of regulators world-wide appears to be entrenched and I doubt we will see any easing of restrictions on short sales any time soon.

We will probably also see a clamp-down on sales practices and not just in the brokerage industry. In Canada and the United States, selling asset-backed securities on the basis that they are as safe as houses has tied up a lot of people's savings indefinitely, and predatory mortgage lending in the U.S. has rendered houses considerably less safe. We can probably expect a tightening up of exempt transactions along with more detailed and focused risk disclosure requirements.

In Canada, sales of asset-backed securities were exempt if the securities had a credit rating. Credit rating practices have been called into question, and we can expect to see credit rating agencies subject to greater regulation and possibly self-regulation.

We may also see new financial certification coupled with stress testing requirements for public companies. This may be counterproductive; arguably one of the causes of the current mess is that the Sarbanes Oxley Act has forced management to focus on the wrong things.

The Financial Crisis I: It's the Governance, Stupid!

2008-11-24T10:32:00.001-08:00

We are seeing the butterfly effect writ large: a family in suburban Pittsburgh can't pay their mortgage, so Iceland goes bankrupt. Or perhaps a better analogy is the 1970s PBS show Connections, where James Burke showed how new inventions are based on older ones (and we wouldn't have modern telecommunications if the Normans hadn't worn stirrups at the Battle of Hastings).

Much has been written about the failure of legislators and regulators, and in a subsequent post I'll be playing pundit and make fearless predictions about regulatory responses. But in this post, I want to look at the failure of governance.

All Risk, No Reward

The current recession/depression (call it what you will) came about largely because there were incentives to take huge risks with very little apparent downside.

People bought houses they wouldn't be able to afford when their mortgage interest rate reset because they were told that they would have no trouble refinancing at a more attractive rate when the time came.

Mortgages were packaged and resold to investors, including banks. Normally, this would be a prudent thing, as having a large portfolio of mortgages should mean that most of them are sound and the few that will fail won't have a material impact on the value of the portfolio. What happened was anything but prudent: Because the lenders no longer owned the mortgage (and the risk of default), they were encouraged to lend to everyone in sight, whether or not they were creditworthy. In a recent article in the New York Times, Gretchen Morgenson reports that a mortgage loan underwriter at Washington Mutual was put under intense pressure to approve loans she strongly believed should be turned down.

Companies made investments in complex derivatives. Again, this could be a prudent move, as derivatives can be used to offset risk. However, many companies used derivatives to increase their risk. Although they potentially had good returns, they also had a huge downside risk. In part this was due to the decoupling of compensation from performance and lack of effective board oversight. Executives got substantial bonuses even though the company's stock performed badly. In a worst-case scenario they would be fired and collect huge golden parachute severances.

The net result is a financial crisis that is engulfing companies with exemplary governance practices. The gut response is to take a very cautious attitude and attempt to eliminate all risk. This is neither desirable nor practical. Things will get worse if there is no credit for worthy borrowers. Derivatives, even complex ones, can be an important tool to mitigate risk if used properly.

What to Do? What to Do?

The problem for boards, and audit committees in particular, is how to tell if a financial product is being used properly. This can be daunting when the investment is so complex you need postdoctoral studies in mathematics to understand them. That doesn’t mean they should be necessarily avoided, but they must be carefully scrutinized.

That said, what is a poor audit committee member to do? My advice is simple: don’t be afraid to look stupid. Keep asking questions. It is not necessary that you fully understand the product, but you need to satisfy yourself that management does. Ask questions such as:

What is the maximum downside if everything that can possibly go wrong happens? Don’t accept an answer that a worst-case scenario will never happen. We’ve just seen that it does. If the worst-case scenario is insolvency, the product should either be avoided entirely or only a small investment made.

What other individual factors can affect performance? In other words, what is the total risk involved and is it justified by the return.

How is the risk being monitored? The more significant the risk, the more closely it must be managed. This may mean real-time risk management.

What are the market signals that will indicate a position should be unwound? How easily can that be done? What if there is no liquidity in the market at that time?

These are just a few of many questions. If answers are evasive or unclear, it may either indicate that management knows the position has more risk than the board will be comfortable with or that they don’t fully understand the risks themselves. To turn an old cliché on its head, in these cases it is far better to speak up and be thought stupid than to remain silent and remove all doubt when the company goes under.

Securities Class Actions and Discovery

2008-11-19T11:18:00.000-08:00

As I was reading the Globe and Mail this morning, I saw an article about an Ontario Superior Court decision in Silver v.Imax Corp., upheld on appeal, that the test for questions on cross-examination on affidavits prior to class certification is that the question have a "semblance of relevance." The defendants had argued that "there is no pre-action right of discovery and as a general rule a plaintiff cannot compel production and disclosure from a prospective defendant" but in the view of Madame Justice Van Rensburg were not able to come up with a workable alternative.

I hadn't been aware of this one, but it raises interesting issues. This is the first case to deal with Part XXIII.1 of the Securities Act (Ontario), which imposes civil liability for secondary market disclosure. The defence bar is up in arms, saying that this will tie corporate executives up dealing with plaintiffs' fishing expeditions, effectively forcing them to discuss a settlement. The plaintiffs' bar feels that they are dead in the water if they can only have access to materials that are already in the public domain as they have to obtain leave from a judge to commence the action and in so doing, must prove they have a reasonable chance of success. In fact, both sides may rue this decision.

The Toronto Stock Exchange Committee on Corporate Disclosure (more commonly known as the Allen Committee after its chair, Tom Allen), for which I was TSX staff co-ordinator, considered whether there should be constraints on the abilities of plaintiffs to commence class actions. The context was the situation in the United States, where entrepreneurial plaintiff's lawyers would launch a class action immediately following a significant drop in a company's stock price. The demands on executives’ time (particularly in open-ended discovery) and uncertainty of litigation were so great that companies would settle cases that had little or no merit.

While the Committee was deliberating its final report, the U.S. Congress adopted the Private Securities Litigation Reform Act, which attempted to address some of the most egregious abuses. One of the major provisions of that Act (now § 27(b) of the Securities Act of 1933) deals with discovery, stating that ‘[i]n any private action arising under this title, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds, upon the motion of any party, that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.”

I had thought that the requirement that leave be obtained for class actions originated with the Allen Committee, but on rereading their report I realized that I had, to quote the outgoing U.S. President, “misremembered.” The Committee considered a requirement that the securities commissions act as a gatekeeper, but felt that the existing disincentives to litigate in Canada would act as a sufficient deterrent to meritless actions. In fact, some on the Committee were concerned that the chance of a lawsuit was still so low that the threat of litigation would not be a sufficient incentive for companies to improve their disclosure practices (and, it was hoped, avoid ever making the misrepresentations that would land them in hot water).

With the courts grappling with the parameters for class actions (and whether to grant leave to proceed) for the first time, I think it is important to remember basic principles. The requirement for leave was not, I think, to balance the fact that plaintiffs do not have to prove reliance on a defendant's misrepresentation, as argued by the defendants. Having a requirement that a plaintiff prove reliance would make the liability provisions self-defeating. Class actions would not be possible as the individual issues (whether a given plaintiff was aware of a misrepresentation and relied on it to his or her detriment) would overwhelm the common ones. The amount an individual shareholder lost in any given instance would generally be too small to justify litigation.

The requirement for leave addresses the abusive litigation seen in the United States. It would make sense to leave the threshold for leave fairly low so that extensive discovery is not needed. Otherwise, the court could end up engaging in a mini-trial simply to decide whether there should even be a trial. That would serve neither plaintiffs nor defendants. The test should be whether the plaintiff has pled with such particularity that it is clear the lawsuit has merit and should proceed, with discovery falling after certification. If, on the other hand, the plaintiff's position is "we're pretty sure there's been a misrepresentation but won't know for sure until we've looked at everything the defendant has," leave shouldn't be given as the suit is clearly speculative.

It is unfortunate if courts hold the plaintiff to such a high standard that all of the litigation tactics normally seen at trial were used for leave applications. This will ultimately cost both plaintiffs and defendants and is not the outcome I believe the legislature had in mind when it adopted the civil liability provisions.

NASAA Announces Core Principles for Co-Regulation

2008-11-19T09:26:00.000-08:00

The North American Securities Administrators Association, which is the umbrella organization for American state and territorial securities regulators (and which includes Canadian and Mexican regulators), has issued five core principles for strengthening the United States' financial services regulatory structure:

Preserve the system of state/federal collaboration while streamlining where possible;
Close regulatory gaps by subjecting all financial products and markets to regulation;
Strengthen standards of conduct, and use “principles” to complement rules, not replace them;
Improve oversight through better risk assessment and interagency communication.
Toughen enforcement and shore up private remedies.

This is the latest in NASAA'a efforts to prove its relevance. Despite the popular misconception here, the U.S. does not have just one securities regulator, but more than 50. The state regulators champion the fact that, for them, investor protection is paramount and in the past have viewed the SEC's emphasis on full, true and plain disclosure with suspicion. They have blocked SEC attempts to ease capital raising by refusing to adopt exemptions from their rules for financings done under SEC rules they considered inadequate.

Although the U.S. Congress has limited the states’ ability to regulate, they have not eliminated it completely. There have been a number of times recently where the states, not the SEC, took the enforcement lead, most notably in prosecuting analysts who were issuing “buy” ratings for stocks they personally believed were bad investments (and, less successfully, going after Richard Grasso of the NYSE for excessive compensation).

The core principles clearly see an important continuing role (albeit “streamlined”) for the state regulators by calling for greater collaboration and communication. The call to close regulatory gaps appears to herald a return to the old days where the states would block federal deregulation attempts.

One area of concern is that principles “complement” rather than replace rules. Normally a regulatory regime is comprised of principles supplemented by guidance or rules supplemented by interpretations. The idea the principles complement rules suggests that a principle could be used to expand enforcement jurisdiction to activities that are not specifically prohibited. This is similar to the ability of Canadian securities commission to take action against activities that are contrary to the public interest, which has been subject to much criticism for vagueness.