Proposed Amendments to Strengthen Short Selling Regime: CIRO Seeks Stakeholder Feedback on Mandatory Close-Out Requirements

Proposed Amendments to Strengthen Short Selling Regime: CIRO Seeks Stakeholder Feedback on Mandatory Close-Out Requirements

On January 9, 2025, the Canadian Investment Regulatory Organization (“CIRO”) published Notice 25-0001 – Proposed Amendments Respecting Mandatory Close-Out Requirements (“Notice 25-0001”), which proposes amendments to the short selling regulatory framework under the Universal Market Integrity Rules (“UMIR”) and the Investment Dealer Partially Consolidated Rules (“IDPC”). The amendments are designed to reduce persistent settlement failures by requiring applicable dealer members that are investment dealers (“Investment Dealer Members”) to:

1. close out a fail-to-deliver position in a listed security in the event of a settlement failure at the clearing agency by specified timelines by buying or borrowing shares,
2. pre-borrow the affected security where there has been a failure to close out by the specified timelines for all future short sales in that security,
3. provide certain reporting and notifications with respect to the mandatory close-out requirements, and
4. have a reasonable expectation to settle on the settlement date for Investment Dealer Members that are not Participants[1] under UMIR (collectively, the “Proposed Amendments”).

The Proposed Amendments are open for comment until April 10, 2025.

Background

Short selling practices in Canada have come under some scrutiny in recent years, prompting efforts from regulatory authorities to modernize the regulatory framework. In January 2021, in response to concerns raised by stakeholders, the Ontario Capital Markets Modernization Taskforce released its Final Report recommending reforms to Ontario’s short selling regime. The Final Report highlighted the disparity between Ontario’s regulatory framework and other jurisdictions, such as the U.S., where mandatory close-out provisions are already in place. In December 2022, CIRO and the Canadian Securities Administrators (“CSA”) published their Joint CSA and IIROC Staff Notice 23-239 Short Selling in Canada (“Staff Notice 23-239”) seeking feedback from stakeholders on Canada’s short selling regulatory framework. In response, several commenters expressed support for introducing mandatory buy-ins or close-outs of short positions. After CIRO and CSA published their response to the feedback received in Staff Notice 23-239 in November 2023, they established a staff working group to assess whether additional short selling requirements, such as mandatory close-out provisions, would be suitable in the Canadian context. This led to the publication of the Proposed Amendments for comment.

Proposed Amendments

1.    Mandatory Close-Out of Fail-to-Deliver Positions

Currently, mandatory buy-in/close-out rules do not exist as a universal national standard under UMIR. However, CDS Clearing and Depository Services Inc. and Canadian stock exchanges have buy-in processes that allow enforcement of the seller’s settlement obligations for failed trades.

Pursuant to the Proposed Amendments, Investment Dealer Members that are members of a recognized clearing agency[2] (“Clearing Members”) would be required to close out a fail-to-deliver position within specified timelines by:

1. purchasing or borrowing shares so that the fail-to-deliver position becomes a net flat or a net long position at the clearing agency, or
2. allocating all or part of the position to another Investment Dealer Member (“Allocated Member”) for which the Clearing Member clears or settles trades. The Allocated Member would then be responsible for closing out the allocated fail-to-deliver position by purchasing or borrowing shares until such position is reduced to a net flat or a net long position at the clearing agency. The allocation of a fail-to-deliver position – which must be done in a reasonable and timely manner – would not extend the timeline for closing out the position.

Under the Proposed Amendments, Clearing Members or Allocated Members would be required to close out a fail-to-deliver position that resulted from a sale by no later than the trading day after settlement date (S+1). However, if the Clearing Member or Allocated Member can demonstrate through their books and records that:

1. the fail-to-deliver position was a result of a long sale, the timeline to close out would be S+3,
2. the fail-to-deliver position was a result of a transaction by a person with marketplace trading obligations who was acting in that capacity, the timeline to close out would be S+3, and
3. the fail-to-deliver position was a result of a sale of a security that the Clearing Member or Allocated Member (or the client they are acting for) is deemed to own, the timeline for delivery would be as soon as all restrictions on delivery have been removed and, in any case, no later than 35 calendar days after the trade date.

The Proposed Amendments set out circumstances where a Clearing Member or Allocated Member is deemed to own a security. It is also noted that the reasonable expectation to settle a trade standard in UMIR Policy 2.2 and UMIR 3.3 and proposed for IDPC Rule 4782 will be amended or include, as the case may be, these provisions to reflect the deemed to own exemption. As a result, rather than requiring a reasonable expectation to settle on settlement date, in the case of deemed to own securities, the seller is expected to have a reasonable expectation to deliver the security as soon as all restrictions on delivery have been removed, and in any case by no later than 35 calendar days after trade date.

2.    Consequences for Failing to Close Out: Pre-Borrow Requirements

Under the Proposed Amendments, if a Clearing Member or Allocated Member holds a fail-to-deliver position for a security, they would be required to pre-borrow that security for all future short sales involving the same security. This requirement would continue for the affected security until the fail-to-deliver position has been closed out by purchasing or borrowing shares to demonstrate a net long or net flat position on their books and records. These pre-borrow requirements would also apply to any security marked as short-marking exempt.

3.    Reporting and Notification Requirements

The Proposed Amendments would impose certain reporting and notification requirements to facilitate the operation and oversight of a mandatory close-out framework in Canada. The proposed requirements include the following:

• where a fail-to-deliver position was reasonably and timely allocated to an Allocated Member, the Clearing Member would be required to submit certain prescribed information directly to CIRO,
• a Clearing Member would be required to notify their clients that are Investment Dealer Members when (i) the Clearing Member fails to close out on time and automatically becomes subject to pre-borrow requirements, and (ii) the Clearing Member subsequently purchases or borrows shares to close out the fail-to-deliver position. Similarly, an Allocated Member would be required to provide the same notifications to the Clearing Member that allocated the fail-to-deliver position to them, and
• where a Clearing Member or Allocated Member uses another Investment Dealer Member to execute trades on a marketplace, the Clearing Member or Allocated Member would be required to notify the Investment Dealer Member when (i) the member fails to close out on time and automatically becomes subject to pre-borrow requirements, and (ii) the member subsequently purchases or borrows shares to close out the fail-to-deliver position.

Where the Clearing Member or Allocated Member is required to notify another party as described above, they will also be required to send a copy of the notification to CIRO.

4.    Reasonable Expectation to Settle for all Investment Dealer Members

In addition to mandatory close-out requirements, CIRO is proposing to extend the requirement for a reasonable expectation to settle trades that resulted from an order to sell a listed security to all Investment Dealer Members. The current rules only require Participants and Access Persons[3] under UMIR to have a reasonable expectation to settle a trade on the settlement date.

Under the Proposed Amendments, if a seller is deemed to own a security, CIRO would require the Investment Dealer Member to be reasonably informed that the seller has a reasonable expectation to deliver the security as soon as the restrictions on delivery have been removed and, in any case, no later than 35 days after the trade date.

Request for Comments

In addition to requesting general comments, CIRO has included a list of questions for stakeholders to consider when making submissions. Topics include whether:

• the Proposed Amendments could create an incentive for Investment Dealer Members to seek entities not regulated by CIRO for clearing purposes;
• Clearing Members or Allocated Members have books and records already in place to be able to close out in the time and manner proposed;
• the requirement to settle one day after the trade day negatively affects the ability of Clearing Members to allocate fail-to-deliver positions within the specified timelines;
• the requirement to file an extended failed trade report should be repealed or narrowed given that CIRO expects most failed trades to be settled prior to the 10-day threshold (which triggers the requirement to file an extended failed trade report);
• there would be any operational or technical challenges associated with the notification and reporting requirements given that some Investment Dealer Members use different entities for clearing and trading purposes;
• there are any common practices that may raise issues in complying with the close-out or pre-borrow requirements;
• the notification and reporting requirements are feasible;
• an extended close-out timeline of T+35 calendar days is appropriate for deemed to own securities; and
• an implementation period of 6 months for the Proposed Amendments is appropriate.

Preliminary Comments

As stated in the Notice 25-0001, CIRO proposed that the purchases of securities to close out a fail-to-deliver position is expected to be under reasonable commercial terms whereby Clearing Members or Allocated Members would not be required to purchase securities at a greater price than a certain premium. However, this language has not been incorporated into the Proposed Amendments to UMIR and IDPC rules. Notably, question 6 invites stakeholders to contemplate the relevant factors or considerations when ensuring that purchases made on a marketplace to close out fail-to-deliver positions are executed under reasonable commercial terms in a manner consistent with market integrity. It is critical to clarify what constitutes “reasonable commercial terms,” how the premium will be determined, and whether alternative methods will be available to close out fail-to-deliver positions when such purchases are deemed not to be under reasonable commercial terms.

We note that the mandatory close-out and pre-borrow requirements under the Proposed Amendments are substantially identical to Regulation SHO in the U.S., which highlights the significance of any departure from Regulation SHO, such as the proposed premium threshold exception. CIRO’s proposal for a premium threshold exception does not appear to align with Regulation SHO in the U.S, and this divergence warrants further scrutiny. Additionally, question 12 addresses whether the rule should differ from Regulation SHO by asking whether a more significant remedy should exist for failing to close out, such as a prohibition on all short sales.

Further, we believe it is important for market integrity that the existing buy-in regimes remain in place with the Proposed Amendments as they are necessary to function in conjunction with the proposed mandatory close-out regime. These details are essential, and we anticipate that market participants will focus their comments on this issue.

McMillan LLP has previously published an extensive study on the short selling regime in Canada. We intend to provide a more comprehensive response to the Proposed Amendments with input from our clients and other market participants. If you have any comments related to the Canadian short selling regulatory framework and the issues surrounding mandatory close-out requirements, please contact any member of our Capital Markets group.

[1] “Participant” is defined in UMIR, and means generally, (i) a dealer registered in accordance with securities legislation of any jurisdiction and who is a member of an Exchange (as defined in UMIR), a user (as defined in National Instrument 21-101 – Marketplace Operation (“NI 21-101”)) of a recognized quotation and trade reporting system, or a subscriber (as defined in NI 21-101) of an alternative trading system; or (ii) a person who has been granted trading access to a marketplace (as defined in NI 21-101) and who performs the functions of a derivatives market maker (as defined in UMIR).
[2] It is proposed that this term be defined in IDPC Rule 4781 and currently only one is recognized, being The Canadian Depository for Securities Limited and CDS Clearing and Depository Services Inc.
[3] “Access Person” is defined in UMIR, and means a person, other than a Participant, who is a subscriber or a user.

By Paul D. Davis, Leila Rafi, Shahen Mirakian, Ouvedi Rama Naiken, Karan Lall (Articling Student)

A Cautionary Note
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
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