1. Background

On June 15, 2016, IIROC hosted a roundtable to discuss issues affecting small-cap issuers. The purpose of the roundtable was to provide stakeholders with the opportunity to present their analysis of specific current market structure issues affecting this sector of the Canadian equities market and offer opinions about appropriate regulatory responses for discussion.1

This notice provides a summary of the issues and suggestions raised by the presenters.

The forum was hosted by IIROC in Toronto. IIROC had originally proposed to hold two sessions, one in Toronto and one in Vancouver but all interested participants preferred to participate in the Toronto session and so only it was held. The forum consisted of presentations from each stakeholder (“presenter”) followed by roundtable discussions with all Presenters and others in attendance, which included IIROC staff, representatives from the Canadian Securities Administrators (“CSA”) and the Government of Ontario. Following the roundtable, IIROC staff met with the market structure group of the CSA to discuss the themes and suggestions raised at the roundtable.

Included as appendix A are references to certain regulatory initiatives that relate to some of the themes discussed at the roundtable. We thank those who responded to our request for proposals and participated in the roundtable.

2. Themes of the Roundtable

The following is a description of the main themes that emerged from the roundtable discussions as well as the specific issues and potential regulatory responses recommended by the presenters.

1. Differentiation between large cap and small cap securities needed

Some presenters suggested that since small-cap securities trade in such a different manner from large-cap securities, securities regulation should reflect these differences. Presenters pointed out that many small-cap securities listed on the TSX Venture Exchange or Canadian Securities Exchange trade infrequently, and that while certain regulatory requirements may not adversely affect large-cap, liquid securities they could have a detrimental effect on small- cap, illiquid securities (for example, see discussion on short selling below). A presenter noted that using the term Small-Cap is too broad to address issues pertaining to Micro-Cap securities. Presenters also noted that regulation in other industries already considers this differential impact and treats enterprises differently according to size (e.g. Income Tax Act).

Presenter Suggestions

1. Move away from a ‘one size fits all’ approach to market structure and modify current rules to address the trading differences between large- and small-cap securities.
2. Conduct a study on the characteristics of non-marginable securities to determine whether using margin eligibility2 would serve as a useful differentiator between large- and small-cap securities.

2. Reduced liquidity in small-cap securities

Presenters expressed concern about the reduction in small-cap security liquidity. They explained that historically independent Dealer Members and individual advisors have been the primary providers of liquidity in small-cap securities and the main distribution channel for new equity issues in these securities. However, the decline of these independent dealers has contributed to the lack of liquidity in small-cap securities and resulted in new equity issues becoming the predominant price discovery mechanism for small-cap securities rather than secondary market trading.

1. Lack of Recommendations to Invest in Small-Cap Securities

Another contributing factor to the reduction in small-cap liquidity mentioned was that many Dealer Members do not feel comfortable in recommending small-cap securities to retail clients in light of IIROC suitability rules and the Client Relationship Model. Presenters felt that this practice not only contributed to reduced liquidity but also negatively affected price discovery in small-cap securities.

Presenter Suggestion

1. Clearly allow 5-10% of retail client portfolios to include small-cap securities in IIROC rules.

2. Periodic Call Auctions

Some presenters suggested that a periodic call auction3 would be a more appropriate method for trading illiquid small-cap securities than the continuous auction market model currently used.

The cited benefits of using a periodic call auction to trade small-cap securities included:

• the aggregation of buyers and sellers who may not be present at the same time in illiquid securities
• improved price formation
• improved size discovery
• the elimination of any speed advantage as there is no price/time priority
• a levelling of the playing field in terms of information dissemination and reaction to news
• an inhibited ability to drive down price through repeated short selling as auctions are only held at specific times.

Securities could participate in a periodic call auction based on various factors, including:

• liquidity thresholds such as share turnover, market capitalization, and average daily trading volume
• voluntary issuer participation
• a combination of the above.

Presenters noted that centralizing the trading of call auction securities onto one market would be vital in maximizing the benefits of this proposal. It was argued that, currently, trading volume in less liquid securities is already generally highly concentrated on one marketplace; this, in turn, demonstrates that competition resulting from the ability to trade small-cap securities on multiple marketplaces may not be delivering sufficient value to investors while adding costs due to marketplace fragmentation. Presenters pointed out that similar models for less liquid securities are currently in operation in the U.S. and Europe.

Other presenters raised concerns with this proposal, including that:

• limiting trading of small-cap securities to only one marketplace may be seen as anti- competitive
• the “illiquid” status of certain small-cap securities may change depending on the trading day and further study is required to determine whether there is consistency around the groupings of illiquid small-cap securities
• continuous auction markets in the U.S. may compete with Canadian call auctions should participating small-cap securities become more actively traded
• Dealer Members may opt out of trading small-cap securities altogether under the periodic call auction model due to additional technology burdens
• without volatility controls, the price of a security in a call auction could be driven down drastically if an investor with a large number of outstanding shares wants to sell his or her position.

3. Small-Cap Issuer Trading Account

A presenter suggested the creation of a Small-Cap Issuer Trading Account. As proposed, a small-cap issuer would hold an account at an IIROC Dealer Member to facilitate a more direct connection between issuers and investors.

The purpose of this account would be to provide an issuer with greater control over the secondary market trading of its security by allowing the issuer to:

• buy back its securities when the price is low, using automatic approvals for Normal Course Issuer Bids (“NCIBs”), and sell its securities into the secondary market from treasury when investor demand increases,
• cover short sales by issuing new shares from treasury.

To prevent abuse, it was suggested that trading in the account could be subject to volume limits (e.g. 10% of the public float) and/or price collars.

Some roundtable attendees expressed concern that this type of activity, under other circumstances, could be considered manipulative and therefore prohibited. Other presenters supported the concept of relaxing or updating NCIB rules, which are viewed as complex and arbitrary.

3. Capital Formation Challenges in Small-Cap Securities

Presenters explained that small-cap issuers are moving away from raising funds through IIROC dealers because prospectus-type offerings have become too expensive. Instead, small-cap issuers are increasingly looking to the exempt market, including offerings such as crowd funding, to raise money. A presenter noted that new equity issues are a dominant price discovery mechanism for Micro-Cap issues rather than secondary market trading which can be limited.

1. Harmonization of Crowd Funding Rules and Use of Social Media

Certain presenters called for the harmonization of crowd-funding rules across Canada to reduce costs and inefficiencies. These presenters were also concerned about the over- reliance on accredited investors for raising funds and expressed the need to develop a new investor client base. Presenters mentioned that contact with the millennial generation has been hindered by the current prohibition on advisors from using social media and recommended greater flexibility with respect to using new methods to reach out to this potential new group of investors.

Presenter Suggestions

1. Harmonize crowd-funding rules and integrate the regulations into IIROC rules.
2. Survey Dealer Members to determine the amount of solicitation for orders in small-cap equity issues and find out how many advisors are actively calling investors and offering new equity issues in small-cap securities.
3. Allow use of social media to reach out to new investors for fundraising.

2. Financing regime similar to Regulation A+ of JOBS Act

A presenter recommended adopting a financing regime that facilitates fundraising at a lower cost, similar to Regulation A+ of the JOBS Act in the U.S. (“Reg A+”). Reg A+ allows prospectus-exempt financings for public companies and allows issuers to “test the waters” and check for interest of whether a financing is viable by marketing over the internet to solicit investors before committing to a financing. A presenter mentioned that Canadian reporting issuers are also eligible to raise money from accredited investors and individual investors in the U.S. under Reg A+, subject to a dollar limit.

Presenter Suggestion

1. The CSA should consider expanding the exempt market in a way that is similar to Reg A+ to allow Canadian companies to broaden their shareholder base using technology to reach the next generation of investors.

4. Microstructure Issues

1. Short Selling and the Tick Rule

The presenters discussed short selling in illiquid securities and the perception that short selling in illiquid securities results in downward price pressure from selling that occurs on a downtick. The participants expressed concern that the perception of a negative impact (real or otherwise) leads to lower investor confidence and lack of participation. Furthermore for Small-Cap issuers, many without significant revenue and rely on treasury financings to execute their business plans, the negative impact of short selling may be a significant hurdle to overcome.

Some presenters advocated prohibiting short selling on a downtick (“Tick Rule”) for small-cap illiquid securities, especially for those that trade at less than $0.10 per share or unit. A key price level for small-cap companies is $0.05 per share or unit due to restrictions in exchange rules on fundraising absent an exemption.4 Specifically, if its stock price falls below $0.05, the issuer loses the ability to raise funds on a continuous basis.

Some presenters noted issues associated with re-introducing the Tick Rule, including:

• compliance with the rule would require a technology build by Dealer Members or marketplaces
• implementation of the Tick Rule across multiple marketplaces is complicated by the fact that market participants receive data at different speeds which can create issues in determining the last sale price
• the Tick Rule may restrict liquidity, as certain orders would not be able to execute.

Instead of re-introducing the Tick Rule, certain presenters suggested using a post-only tag for short sales of small-cap securities, whereby a short-sale order could only be posted and not actively execute when entered on a marketplace. This alternative would prevent active shorting of a small-cap security. It was also suggested that exemptions from this potential requirement could be provided to market makers registered with the marketplace so that they may continue to conduct their role effectively.

Finally, presenters noted the widely-held view among junior issuers that there is often downward pressure on the price of a small-cap security when a company issues a positive news release.

Presenter Suggestions

1. Prohibit short selling on a downtick for small-cap illiquid securities, especially those that trade at less than $0.10 per share or unit.
2. Conduct studies to determine whether controls in the following forms would be appropriate:
   1. re-introduction of the Tick Rule for small-cap securities, and
   2. introduction of a post-only tag for short selling in small-cap securities.
3. Conduct a study on predatory short selling practices to determine if there is downward pressure on small-cap securities following a favourable news release.

2. Settlement Discipline

Some presenters expressed concern that certain IIROC Dealer Members are unlawfully allowing short sales to occur to the detriment of shareholders and the issuers of these securities. Specifically, there is a perception among small-cap issuers that the back offices of certain IIROC Dealer Members allow for delayed delivery to cover short sales, contrary to current rules.

Presenter Suggestion

1. Conduct a study on failed trades5 targeted at trading in small-cap securities with respect to short sales, and examine whether Dealer Members are covering short sales in small-cap securities by the settlement (requisite) date.

3. High Frequency Trading and Volatility

Some presenters indicated that their analysis shows no high frequency trading in small-cap securities. These Presenters surmised that there is insufficient liquidity in the small-cap market to support strategies that effectively require trading accounts to be flat at the end of the day.

Presenters explained that price volatility is welcome for small-cap securities because this type of trading is event-driven, sporadic and occurs around news events. Since muting volatility hampers natural trading in small-cap securities, presenters suggested that regulation should not attempt to control market prices.

Presenter Suggestion

1. Review whether High Frequency or electronic trading patterns that probably reduce volatility is appropriate for a Small Cap market.

4. Board Lot Size and Tick Size

Certain presenters did not support increasing the board lot size for small-cap securities as it would lead to more retail investors holding odd-lot positions. It was noted that while odd-lot market makers exist for all securities, a larger board lot size could exacerbate liquidity issues if the spread was too wide.

As well, presenters did not support changing the tick size for lower-priced securities as they did not feel it would promote liquidity. Some presenters argued that changing the tick size might result in decreased order sizes at each price level and increase volatility as active orders must execute through more layers of the order book.

5. Promote education efforts collectively as an industry

All Presenters encouraged IIROC to further develop education efforts on market structure issues in this area as this would effectively help restore investor confidence.

Presenters also agreed that marketplaces, Dealer Members, advocacy groups and other representative communities have a role to play in promoting dialogue and understanding of market structure issues.

3. Next Steps

Many of the issues raised at the small-cap roundtable were outside of IIROC’s jurisdiction; however as noted above, representatives of the CSA did attend the Roundtable. IIROC has reviewed the comments received that relate to issues that are within their jurisdiction and will be taking the following steps:

• Review the current short position reporting requirements to determine whether there are steps that can be taken to make the reporting more meaningful.
• Review the frequency of the current reporting of short activity made available by IIROC on its website to determine whether more frequent reporting would be beneficial. This together with potential changes to short position reporting would enhance the transparency of short selling activity.
• Refresh the 2007 study of failed trades specifically targeting small-cap securities. IIROC believes that failed trades and overall settlement discipline are a key benchmark when evaluating the overall short selling framework. The results of this study may lead to further targeted work related to other aspects of short selling to determine if any policy steps are required.
• Actively look for opportunities to assist stakeholders to better understand market structure issues affecting small-cap securities.

Appendix A

• 1IIROC published Notice 16-0073 – Roundtable to Discuss Specific Market Structure Issues Affecting Small Cap Issuers (“Roundtable Notice”) and requested interested parties to provide proposals to address market structure issues that affect small-cap issuers.
• 2Securities that trade under $1.50 are not eligible for margin under IIROC Rules. (Dealer Member Rule 100.2(f)(i))
• 3A call auction can be described as a pooling of buy and sell orders which are periodically matched and executed.
• 4See section 2.1 of CSE Policy 6 and TSXV Bulletin on Discretionary Waivers of $0.05 Minimum Pricing Requirement dated April 7, 2014.
• 5Section 1.1 of UMIR provides the definition of “failed trade” to mean a trade resulting from the execution of an order entered by a Participant or Access Person on a marketplace on behalf of an account and
  (a) in the case of a sale, other than a short sale, the account failed to make available securities in such number and form;
  (b) in the case of a short sale, the account failed to make:
  (i) available securities in such number and form, or
  (ii) arrangements with the Participant or Access Person to borrow securities in such number and form; and
  (c) in the case of a purchase, the account failed to make available monies in such amount, as to permit the settlement of the trade at the time on the date contemplated on the execution of the trade provided a trade shall be considered a “failed trade” irrespective of whether the trade has been settled in accordance with the rules or requirements of the clearing agency.