In an effort to make Ontario “one of the most attractive capital markets in the world”, the province is considering a slew of reforms proposed by its Capital Markets Modernization Taskforce. And one of those reforms takes aim at a certain short-selling practice that they say has been harming the market.
Something highly irregular has been going on in the junior capital markets: the shorting of new stock issued typically by smaller companies. The practice was especially frequent during the cannabis frenzy when an ebullient market created ripe conditions for it.
“It’s the kind of stuff you could see happening in the underworld,” states Anthony Scilipoti, president and CEO of Veritas Investment Research Corporation, who also sits on an advisory board of the Ontario Securities Commission.
An Arrangement
As Scilipoti explains, the practice supposes a convenient arrangement between hedge funds, underwriters and company owners. A hedge fund borrows shares from company owners to short sell stock ahead of the public offering. Once the issue comes through, the hedge fund buys back the stock, pocketing the profit reaped from the higher price of the short sale and the lower one of the issue purchase.
Scilipoti illustrates the result through a hypothetical example. Suppose a company wants to go public. The insiders may negotiate with their underwriter, prior to the listing, securing a price through a stock short sale with a hedge fund at say $20. Then the issuing company markets the IPO at say $15. The short sellers then close out their position as part of the offering, netting a $5 profit (the difference between the $15 IPO and the $20 short sale; for simplicity we exclude associated fees and interest costs). The IPO volume ensures the offering is completed and amplifies the impression of activity to the marketplace, “while the company insiders receive higher proceeds than the company,” explains Scilipoti.
The scheme carries many ‘advantages’: it creates an illusion of heightened activity, sometimes even a frenzy, around an offering through both the short sell of the stock and its subsequent buyback, the hedge fund and the owners who participate in the deal reap a profit from the short sale, and they all finally pick up a stock at a discount. Everyone seems to win in the manipulation, even investors who can come into a stock at a lower price.
Not quite. “This harms the corporation, its shareholders and the uninformed investors trading against the short sellers,” writes the Taskforce in its recent consultation report. The company may receive less capital than it planned for, buyers of the stock can see their investment tank from $15 to $5, and “a company that probably should not have gone public still goes public, highlights Scilipoti. The outside market is not getting full transparency on fair value because a lot is happening in the background.”
A Straightforward Ban
What the task force proposes is “a rule that would prohibit market participants and investors that have previously sold short securities of the same type as offered under a prospectus or private placement from acquiring securities under the prospectus or private placements.”
The existing rules make such market manipulation and insider trading difficult to prosecute because one has to prove intent. In the United States, where rules banning such practices have been passed, there is no need to prove intent. The ban proposed by the Taskforce “aims at aligning Canada’s regulation with that in the U.S.,” says Scilipoti, who believes the ban will pass.
Even though the scheme animating junior capital markets was reprehensible, it still allowed companies to have access to capital, something increasingly difficult to accomplish, recognizes Scilipoti, and which the ban will not make any easier.
That’s why the task force put forward a number of other proposals to facilitate raising capital for junior companies, notably introducing a category of mutual funds habilitated to invest in small business private placements, similar to the interval funds model in the U.S.; streamlining the offering model for reporting issuers; widening categories of accredited investors; facilitating the process for companies to premarket deals.
Because the proposed ban targets only prospectus offerings and private placements, accredited investors will be the first ones to be impacted by it. Will it affect general retail investors who are moving into liquid alt funds, which are authorized to short-sell stocks? Maybe, but hard to tell, since it depends on the investing practices of specific funds.
The Rules of Responsible Investing
Understand how ESG regulations affect investors in our latest report here
:quality(80)/cloudfront-us-east-1.images.arcpublishing.com/morningstar/GDTOG6TCABG2VER32KWOKC6ZJ4.png)
