Short-Selling Structure Not Abusive—Ontario Capital Markets Tribunal Dismisses OSC Allegations in High-Profile Enforcement Proceeding

December 04, 2024

Written By Alan Gardner, Amanda McLachlan and Shaan Tolani

In recent years, the OSC and other regulatory bodies began signaling to public markets that regulators intended to crack down on what they termed abusive short-sellers. Against this backdrop, the OSC brought enforcement proceedings before the Ontario Capital Markets Tribunal (CMT) naming Cormark Securities Inc. (Cormark), Saline Investments Ltd (Saline), and individuals as respondents. The proceedings focused on an alleged illegal and abusive short selling scheme. At the conclusion of a lengthy hearing on the merits, the CMT dismissed all of the OSC’s allegations.

The CMT’s decision provides helpful guidance for reporting issuers and contracting parties with respect to how securities regulators in Ontario may scrutinize a share transaction.

The OSC Enforcement Proceeding

The OSC alleged that: (1) the transactions resulted in an illegal distribution and (2) the OSC’s public interest jurisdiction was engaged.

The transactions at issue (the Transactions) related to Canopy’s addition to the S&P TSX Composite Index:

• 2.5 million Canopy common shares, that were subject to a four-month hold period, were sold to Saline Investments Ltd. (Saline) in a private placement (the Hold-Period Shares).
• Saline borrowed 2.5 million free-trading Canopy shares (the Free Trading Shares), using the Hold-Period Shares as collateral to do so.
• Saline then short sold 2.5 million Canopy shares on the open market, which it settled using the Free Trading Shares. Saline then repaid its loan obligations using the Hold-Period Shares.

Following its investigation, the OSC did not allege any wrongdoing by Canopy and did not name Canopy as a respondent in the enforcement proceedings (though there was a disclosure motion that involved Canopy within the enforcement proceeding). Bennett Jones LLP represented Canopy in connection with the underlying OSC investigation and the disclosure motion.

No Illegal Distribution of Shares

In the proceedings, the OSC alleged that Saline effectively converted its Hold-Period Shares into Free Trading Shares, which it alleged amounted to an illegal distribution (i.e., an offering of shares to the public markets that took place without the benefit of a prospectus or prospectus exemption), based on the extended definition of “distribution” under the Securities Act.

The definition of “distribution” under the Securities Act has two arms:

1. A list of six specific types of trades which fall under the term “distribution”.
2. The extended definition of distribution, which includes “any transaction or series of transactions involving a purchase and sale or a repurchase and resale in the course of or incidental to a distribution”.

At the conclusion of the hearing, the CMT found that the Hold-Period Shares and Free Trading Shares were separate and distinct, and continued to co-exist after the Transactions took place. The CMT also found that at all times, the Hold-Period Shares remained in a “closed system”, and the associated hold-period was never displaced. As a result, the Hold-Period Shares were not, as the OSC had alleged, converted and offered to the public. On that basis, the CMT found there was no illegal distribution. In doing so, the CMT also reinforced that the parties’ subjective understanding of the Transactions was irrelevant to the determination of whether a distribution occurred.

Canopy was not a Cormark Client

The OSC further alleged that Cormark failed to deal with Canopy honestly and in good faith. As a threshold step, it was necessary for the CMT to determine whether Canopy was indeed a Cormark client (as defined under OSC Rule 31-505), so as to trigger the fair dealing obligation under the rules.

The CMT reiterated that the assessment of whether or not a client relationship is formed for the purpose of Rule 31-505 requires a case-by-case, contextual analysis. Some factors that may be assessed include whether registrable activities are conducted, receipt of a benefit, formal documentation and the parties’ beliefs. In this case, in concluding there was no client relationship, the CMT found:

• Canopy was a sophisticated party with experienced legal counsel.
• There was no formal client agreement between Canopy and Cormark.
• Cormark only engaged in registerable activities on behalf of Saline, not Canopy.
• Canopy did not engage or pay any fees to Cormark. Rather, fees were paid by Saline.
• The parties never conveyed there was a client relationship in contemporaneous statements.

As a result, Rule 31-505 was never engaged and could not be breached.

No Misconduct Towards Canopy

In deciding whether its public interest jurisdiction was nevertheless invoked, the CMT determined that the respondents did not mislead Canopy such that they failed to act honestly and in good faith towards Canopy. The CMT found no direct evidence that the respondents actively lied about or concealed aspects of the Transactions from Canopy. The CMT further noted that Canopy, naturally, was more focused on its own interests in the Transactions.

The CMT disagreed with the OSC’s characterization that the Transactions resulted in a “virtually risk-free” profit to Saline. It found that the parties had negotiated a floor price for the private placement. If the share price dropped below the floor, it was open to Canopy to walk away from the private placement, which may have left Saline in default of its loan obligations. Moreover, there was no evidence that the risk-reward ratio for Saline affected Canopy’s decision to participate in the private placement.

As a result of its findings regarding the Transactions and conduct towards Canopy (among other things), the CMT held its public interest jurisdiction was not invoked. Accordingly, the CMT dismissed all of the OSC’s allegations against the respondents. In doing so, the CMT concluded that the OSC’s allegations against the respondents “were an overreach”, and came with the “unfortunate consequence” of significant financial and reputational costs for the respondents.

Key Takeaways

• Assuming the use of appropriate prospectus exemptions or prospectuses for constituent transactions, using restricted shares as collateral to borrow free-trading shares is unlikely to be considered an illegal distribution.
• The CMT will assess whether a “distribution” has occurred by looking to objective, rather than subjective, evidence.
• Determining whether a party is another’s client for the purposes of OSC Rule 31-505 requires a case-by-case contextual analysis. Some factors that may be assessed include whether registrable activities are conducted, receipt of a benefit, formal documentation of a client relationship and the parties’ beliefs.

If you have further questions about this decision or securities litigation issues more generally, please contact the authors or a member of the Bennett Jones Securities Litigation group.

The authors would like to thank articling student, Emma Danaher, for her contributions to this article.

Authors