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.

Big Changes Proposed to Ontario Securities Act

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

In addition to numerous clean-up amendments, Bill 135

• allows the OSC to designate credit rating agencies for the purposes of Ontario securities law but not to regulate the content of ratings or the agency's methodologies;


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


• provides a legislative framework for trading derivatives; and


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

Credit Rating Agencies

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

Trade Repositories

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

Derivatives

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

"Derivative" is defined as an option, swap, futures contract, forward contract or other financial or commodity contract or instrument whose market price, value, delivery obligations, payment obligations or settlement obligations are derived from, referenced to or based on an underlying interest (including a value, price, rate, variable, index, event, probability or thing), excluding

• a commodity futures contract as defined in subsection 1 (1) of the Commodity Futures Act,
• a commodity futures option as defined in subsection 1 (1) of the Commodity Futures Act, and
• a contract or instrument that, by the regulations or Commission order is not a derivative.

The bill makes a number of linguistic changes to the Act to accommodate derivatives, such as changing references to "stock exchanges" to "exchanges" and replacing the term "security" (for the most part, but not in all cases) to "security or derivative." To the extent that a particular instrument fits the current definition of "security," there won't be any practical change. However, there are some contracts that might be exempt from the definition before that could now be caught. For example, it is arguable that forward contracts are not "securities" under the current definition unless they could be characterized as "investment contracts."

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

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

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

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

Insider Trading

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

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

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



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

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

Insider Twitting

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

BAIKIE: Yes, sir.

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

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

KINGSFIELD: And it depends on what?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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