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Canada’s regulatory regime for short-selling is woefully inadequate, according to a report published in November by McMillan LLP, a Toronto-based law firm.

The report, Short-selling in Canada: Regulations are Weak and a New Path Forward Is Needed to Reduce Systemic Risk, argues that Canada’s regulation of short-selling is “inherently weak” and “out of step” with rules in other countries.

The report adds that Canada’s regulations on short-selling do not meet global standards that were adopted in the wake of the global financial crisis.

The McMillan report compares the oversight regime in Canada with those of the U.S., the European Union (EU) and Australia, and concludes that Canada’s rules are “more lenient” than regulations in the other markets. This leniency has “negative implications on investor protection and the level of risk in the Canadian marketplace with respect to short-selling.”

The report calls on Canadian regulators to beef up the rules pertaining to short-selling and to step up enforcement activity against abusive short-selling. The report also recommends that policy-makers consider introducing a civil remedy for companies and shareholders harmed by deceptive short-selling campaigns.

“We hope that our recommendations act as a starting point to begin the long public and industry consultation process to determine whether a statutory private right of action can balance … competing policy concerns and provide a means to better address — and deter — abusive short-selling,” the report states.

The argument for creating a mechanism for companies and shareholders to go after abusive short-sellers is that there has been little regulatory enforcement action in this area. Furthermore, Canadian issuers may be particularly vulnerable to short-selling because our regulatory regime is weaker than those in other markets.

The report cites an increase in “short activism,” which involves traders taking short positions in a company’s stock, then championing a negative view on the stock through social media and other channels in an effort to drive the stock’s price down and benefit the traders’ short positions.

The McMillan report cites data from Activist Insight, a New York-based research firm, suggesting that Canadian companies are targeted disproportionately by short-selling activists. Although the number of short-selling campaigns in Canada lags the number in the U.S. over the past few years, the data indicate, short-selling activist efforts in Canada outpace that activity in the EU and Australia.

“With Canada becoming a haven for those who wish to pursue short campaigns, and with short-selling being an important part of our capital markets, we would suggest that regulators need to review short-selling in general,” the McMillan report states.

The Canadian Securities Administrators (CSA) has promised to do just that. A CSA notice issued in November 2018 states the regulator was planning to review activist short-selling in Canada — although that study has yet to materialize.

“The CSA continues to gather information about this initiative and are in the process of planning next steps,” states Kristen Rose, manager of public affairs at the Ontario Securities Commission.

At the same time, the Investment Industry Regulatory Organization of Canada (IIROC) is pushing back on criticism of Canada’s existing short-selling regime.

“IIROC has a robust framework in place to monitor for, detect and intervene in abusive or manipulative short-selling,” says Andrea Zviedris, manager of media relations with IIROC.

IIROC, a self-regulatory organization (SRO), also refutes the contention that Canada’s regulatory regime is falling short of international standards. IIROC points to assessments carried out by the International Monetary Fund (IMF) and the World Bank, which have found that Canada meets the International Organization of Securities Commissions’ (IOSCO) principles for market infrastructure.

The latest IMF review of Canada’s compliance with IOSCO principles, carried out in 2014, found that arrangements to minimize failed trades in Canada “are reasonable, and there are robust reporting requirements in connection with short-selling.”

In the meantime, however, the clamour for regulatory reform on short-selling continues in Canada, particularly on the junior side of the market.

Earlier this year, the TSX Venture Exchange held an industry roundtable that included issuers, investors, traders and others to discuss the health of the venture-capital market in Canada. According to a post-mortem report on the event, the impact of short-selling was one of the concerns flagged by industry participants.

Those participants recommend, among other measures, that regulators consider either bringing back the “tick test” — which restricts short-selling when a stock’s price is dropping — or limiting short-selling activity based on the liquidity or market capitalization of a company. The recommendations also call for regulators to impose consequences on short-sellers for distributing misleading research.

In November, Save Canadian Mining (SCM), an advocacy group, was launched to represent the interests of junior mining companies by focusing on the impact of short-selling on the sector as one of its core issues. SCM is calling for the return of the tick test and for regulators to crack down on misleading short research.

IIROC states that it “welcomes complaints … regarding suspected instances of potentially abusive short-selling and other forms of market manipulation, which we take very seriously.” The SRO notes that it investigates all complaints, and states it will “take action as warranted.”

Yet, according to the McMillan report, cases against allegedly abusive short-selling are tough for regulators to bring forward. For example, to find that a short activist campaign has veered offside, regulators must prove that the negative information being disseminated about a company is false, that the short-seller knew it was false and that the short-seller’s efforts to spread the negative information materially affected a stock’s price.

“In an attempt to balance free speech and protection of the integrity of the capital markets, regulators have placed a high threshold on the type of behaviour required to decisively reach the conclusion that activity should be sanctioned,” the report notes.

Nevertheless, the report calls on regulators to increase their enforcement activity regarding potentially predatory short-selling and to launch a consultation on whether to allow issuers or investors to sue abusive short-sellers.

“With virtually no successful enforcement proceedings in connection with a ‘short and distort’ campaign, as well as little civil litigation, it is clear that there is currently no effective remedy — whether through compliance or the recovery of damages — for target companies or their shareholders,” the report states.

“As such,” the report continues, “we recommend that the CSA consider a statutory private right of action.”