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.
Tuesday, June 14, 2011
Tuesday, May 10, 2011
SCOTUS clarifies materiality standard for corporate disclosure
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.
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.
Tuesday, April 5, 2011
Feds 0-2 on constitutionality of draft securities law
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.
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.
Monday, March 14, 2011
Musings on the Alberta decision on federal securities legislation
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.
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.
Monday, February 14, 2011
Random Thoughts on Regulating the Merged TMX-LSE
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.
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.
Sunday, December 5, 2010
Box Office Futures Make Debut
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:
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.
Thursday, November 25, 2010
Big Changes Proposed to Ontario Securities Act
You wouldn't know it from the title, but Schedule 18 of the Helping Ontario Families and Managing Responsibly Act, 2010 (Bill 135) contains some far reaching amendments to Ontario securities law. Most notably, it contains a legislative framework for regulating derivatives that is missing from both the Securities Act and the Commodity Futures Act.
In addition to numerous clean-up amendments, Bill 135
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
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.
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.
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.
One problem with the bill is that the definition of "security" in the act has not been amended, which means that many contracts will be both "securities" and "derivatives." It would be preferable for the definitions to be exclusive, that is "security" does not include a "derivative." The bill in fact, gives the OSC the authority to rule that certain classes of derivatives are securities.
It would have been even better if the derivatives provisions were incorporated into the Commodity Futures Act, making it a comprehensive body of rules governing exchange-traded and over-the-counter derivatives, similar to what Quebec has done.
In terms of substantive changes, there isn't much in the bill. It allows for registration to trade derivatives. While this is unlikely to affect investment dealers (who are currently permitted to trade them), it would allow for a tailored registration regime for derivative-only firms.
Derivatives are exempt from the prospectus requirements if a disclosure document is prepared and accepted by the Commission. While the content of the disclosure document is not specified, this appears to be a codification of the current prospectus exemption for exchange-traded derivatives provided a risk disclosure statement is first given to the client. This also reflects the reality that each trade in a derivative results in the issuance of a new security because the clearing house becomes a counterparty to each side of the trade.
Insider Trading
The prohibition on trading on the basis of undisclosed material information (and the resulting civil liability for violations) has been extended to TSX Venture Exchange listed issuers that have a real and substantial connection to Ontario. Currently, the prohibition only extends to Ontario reporting issuers.
It isn't clear why this provision is needed, given that section 18 of TSX VE Policy 3.1 requires issuers with a "substantial connection" to Ontario to make a bona fide application to the OSC to become a reporting issuer within six months of it becoming aware that it has a significant connection. The concern might be that these issuers are traded on alternative trading systems in Ontario; previously the trading would have been done on the Venture Exchange and the BCSC and ASC would have jurisdiction. The Ontario government might be concerned that the very people who are responsible for having the company apply to be an Ontario reporting issuer might improperly delay the application to trade with knowledge of inside information. Even so, it is difficult to see why the provisions weren't extended to all TSX VE listed companies (as the gap continues to exist for those that do not have a real and substantial connection to Ontario) or, like section 57.2 of the British Columbia Securities Act, extended to all public companies regardless of reporting issuer status.
“Real and substantial connection” is not defined, and it could prove unworkable if the OSC adopts a different definition from that in the TSX VE’s rules.
There are a number of more minor problems with the bill. It continues the Ontario government’s insistence on putting provisions in the legislation that in other provinces are left to commission rules. In this case, some provision of National Instrument 21-101 Marketplace Operation are brought into the Act. In addition, the current power given to the OSC to suspend trading on a stock exchange in the event of a market disruption is unclear as to whether it extends to quotation and trade reporting systems and alternative trading systems. Although the provision will be amended to allow suspension of trading in securities and derivatives, the ambiguity remains.
This is legislation, not a commission rule, so there is no notice and comment period. However, it is hoped that some of the concerns with the act (which in my case go more to form than substance) can be remedied by the Legislature's deliberations.
Friday, November 19, 2010
CSA/IIROC Position Paper on Dark Markets Released
Following on the heels of studies by the SEC, IOSCO, and the Australian Securities and Investments Commission, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada have released a joint position paper on dark liquidity in Canadian markets.
The paper lists those issues the regulator feeds need to be addressed immediately, and it contemplates amendments to National Instrument 21-101 and the Universal Market Integrity Rules.
The paper defines "dark order" as an order that is entered on a marketplace without being visible to other market participants, and "dark pool" as a marketplace with no pre-trade transparency for any orders. Partially undisclosed orders, such as iceberg orders, are not considered dark orders as they contribute to price discovery.
The main risks dark orders and dark pools pose to capital markets are making price discovery less efficient and reducing liquidity available to all market participants by diverting order flow that otherwise would have gone to visible, public markets. On the other hand, orders are dark because full disclosure of trading intentions may have an impact on the market price, leading to a worse fill. Dark pools offer an alternative to the upstairs market where institutional block orders were traditionally traded. Dark orders also offer potential liquidity to smaller orders that are sent to a dark pool first in search of a better price than that available on visible markets.
The paper sets out the regulators' positions on three issues:
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.
Wednesday, November 3, 2010
Share Structure Concerns in IPOs
The Canadian Securities Administrators recently issued Staff Notice 41-305 concerning share structure issues in initial public offerings.
The purpose of the notice is to put issuers and insiders on notice of the issues that the various commissions will consider when deciding whether issuing a receipt for a prospectus is in the public interest. The primary concern is companies that have issued large amounts of shares for nominal cash consideration (or as payment for assets or services where the value cannot be easily or objectively determined). This is particularly true if the issuer has a limited history of operations and thus is difficult to value and the number of cheap shares issued is large compared to the number of shares to be issued in the IPO.
These issues persist despite the fact that both the TSX Venture Exchange and the Canadian National Stock Exchange have policies that address some of these issues and the CSA itself has an escrow policy that acts to lock up cheap shares issued prior to an IPO.
The notice states that the commissions will consider a number of factors when determining whether a share structure is objectionable. The main consideration is whether public shareholders are getting a disproportionately small ownership stake in the company relative to the amount of money raised in the IPO. On the other hand, staff recognize that management and insiders may have spent considerable time and resources in building the business, and they will consider factors such as whether the value of the shares issued to the insiders can be corroborated by factors such as arm's length pre-IPO financings.
The takeaway is that persons acting for companies that have a lot of cheap or free stock outstanding should have a discussion with commission as well as exchange staff early on in the IPO process.
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.
Wednesday, September 22, 2010
IIROC reports on new product due diligence, principal protected notes
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:
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.
Thursday, August 26, 2010
Securities Regulation in Federal States - Help Needed!
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.
Thursday, August 19, 2010
IOSCO's Principles for Direct Electronic Access to Markets
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:
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.
Wednesday, July 28, 2010
CSA Releases Proposal to Regulate Credit Rating Agencies
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
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.
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.
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.
Monday, June 21, 2010
CSA consults on venture issuer regulation
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.
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.
Wednesday, May 26, 2010
Draft Federal Securities Act Released
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.
Monday, May 3, 2010
British Columbia Introduces Framework for Regulating Credit Rating Agencies
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
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.
Thursday, April 1, 2010
Moody's Less Than Stellar Governance
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
http://insurancenewsnet.com/article.aspx?id=176563&type=newswires
Saturday, March 27, 2010
IIROC issues draft guidance on locked and crossed markets
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
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.
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.
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
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:
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 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).
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.
Sunday, October 18, 2009
The Impossible Scheme - Hong Kong Court Finds Share Splitting Manipulative
Winston Churchill once said that (North) America and Britain were "two nations divided by a common language." I thought of this recently reading the Hong Kong Court of Appeal decision in Re: PCCW Limited.
One thing that has always struck me as peculiar is that some of what we in Canada and the US call "plans" (pension plans, plans of arrangement, etc.) the rest of the common-law world calls "schemes." This gives it a slightly sinister undertone. The PCCW case is about, well, a scheme to ensure a scheme of arrangement got implemented.
The scheme of arrangement in question was a privatisation in which minority shareholders would be cashed out at a premium to market. Despite this, many shareholders complained that they were being taken out at a time when the market price for the shares was at a nine-year low and they would miss an opportunity to profit from a market rise. Proxy advisors unanimously recommended that shareholders not approve the arrangement. The offerors behind the scheme (who would own and control the company if approved) had more than a majority of the shares. However, under the Hong Kong Companies Ordinance a double super-majority (75% of shares and 75% of shareholders) is required to approve an arrangement. At a preliminary meeting, a motion to adjourn was defeated on an initial show of hands.
In order to ensure the approval of the arrangement, some people connected with the offerors devised a plan to induce employees of their firms and friends to buy small amounts of shares. They were also given proxies to vote in favour of the arrangement. One of the persons bought 500 board lots and gave them away to 494 employees as a "bonus." Of the 1404 shareholders who voted in favour of the arrangement, 940 became shareholders after the preliminary meeting.
Under Hong Kong law (as in Canada) an arrangement must also be approved by a court. The arguments raised by PCCW and the offerors were:
(1) The court should not overturn a valid vote of the shareholders (it was conceded by all parties that the new shareholders were registered shareholders entitled to vote);
(2) Shareholders are entitled to vote the way they please; and
(3) So-called "share splitting" is a normal and accepted practice in these situations.
The court dismissed the first argument out of hand, stating that it made the requirement for court approval superfluous. The court had an obligation to review the arrangement regardless of the shareholder vote and ensure it is fair. In particular, the double majority requirements were adopted precisely to ensure the protection of minority shareholders.
The court then examined the other arguments. While shareholders have a right to vote as they wish, it was clear that they were being told to vote in favour in order to ensure a quick profit. The court found it unusual that the proxy forms were not obtained from PCCW but from the deputy chairman of the company instigating the privatisation. As for the argument that share-splitting was an acceptable practice, the court said:
"I do not consider that any right thinking member of society could condone a situation where the law required that a vote should be taken so as to balance the fairness between the holders of shares in different proportions and deliberate steps had been taken to distort that vote; in this case, it may be said, at minimal cost to those responsible. Vote manipulation is nothing less than a form of dishonesty. The court cannot sanction dishonesty."
Thus, attempts to manipulate voting in corporate transactions are unlawful in Hong Kong.
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.
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