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A move to bring Canadian short-selling rules in line with United States securities law could reverberate through Canada’s junior capital markets as regulators look to limit a controversial trading strategy used to finance high-risk companies, notably in the cannabis industry.

Earlier this month, an Ontario government task force recommended banning a sophisticated short-selling technique used by hedge funds active in Canada’s small-cap public markets. Short selling is a bet that a company’s share price will drop.

In anticipation of a financing deal, a hedge fund will short a company’s shares, then buy into the deal to cover the short position, acquiring a block of newly issued shares at a discount to the market price.

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The technique allows funds to earn a quick profit with relatively little risk and makes it easier for investment bankers to find lead buyers for speculative deals. Critics, however, allege the technique often pushes the boundaries of securities law, as investment bankers, company insiders and hedge funds work together to facilitate the short position.

“If this type of short selling is done, and it’s done intentionally with the knowledge of an unannounced transaction that they plan to purchase on, then there is an extremely good chance that it would be violating existing insider trading rules and market manipulation rules,” said Cindy Tripp, a former managing director at GMP Securities and member of the Ontario Capital Markets Modernization Taskforce, which is overseeing a review of the province’s securities laws.

“We were pretty surprised by stakeholders speaking to us about this sort of being routine and being accepted in certain market segments,” she said. “We were also struck at how much potential pressure there is on issuers to go along with this practice in order for them to raise capital.”

In a wide-ranging report published two weeks ago, the task force suggested prohibiting investors from participating in a financing deal if they have previously shorted the same securities. In practice, this would likely involve a restricted period ahead of a deal, similar to what exists in U.S securities law, Ms. Tripp said.

Canadian rules already prohibit insider trading. However, it can be difficult for regulators to prove that a market participant intended to break the law, Ms. Tripp said. “The task force is looking at this in a simple way: How do we simply stop this behaviour?”

The change could have a significant impact on deal-making in speculative sectors such as junior mining, cannabis and psychedelics, industry insiders say. It would make it more expensive for hedge funds to trade around deals and could force investment bankers to rethink how they source capital for high-risk companies.

This kind of transaction has a long history in Canadian junior markets, which are dominated by speculative resource extraction companies, and it became widespread during the cannabis financing boom from 2015 to 2018 as hedge funds recycled hundreds of millions of dollars through multiple deals.

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“There’s sort of this broker, hedge fund complex that was built up over the past many years, precannabis,” said Keith Merker, former chief executive officer of cannabis company WeedMD Inc. “It was, ‘I’ll scratch your back, you scratch mine, and we can do a lot of deals and make a lot of money.‘”

Mr. Merker said he supported the move to limit shorting into deals. At the same time, many speculative companies won’t get funded, for better or for worse, if hedge funds can’t execute these trades, he said.

“On the back of that capital that was quite frankly recycled through the [cannabis] industry time and time again, there was a lot of infrastructure that was built. Some of it’s great infrastructure and it’s going to be the backbone of the Canadian industry going forward, and some of it probably shouldn’t have been built,” Mr. Merker said.

Richard Carleton, CEO of the Canadian Securities Exchange, said the task force recommendation is a direct response to what happened in the cannabis space. He did not, however, think that the rule change would have much of an effect on small-cap markets in the future. The cannabis sector was uniquely fertile ground for investment bankers and hedge funds to deploy this strategy on a marketwide scale, he said.

“You had to have a sector that was liquid, because you had to be able to take on a short position of $40-million to $100-million,” he said. “And you had to have an exuberance over the valuations such that management didn’t really care that somebody had been shorting the hell out of their stock and driving the price down, because they just sort of thought this is just the give-and-take and it will rebound.

“It may be the only circumstance in my 32-odd years in the capital markets where all of those conditions were present to be able to make it work,” he said.

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Ms. Tripp said the proposed rule should help deter inside trading and market manipulation in junior markets. As to whether it will damage small-cap fundraising, she said that other task force recommendations should help offset the effect of the short-selling proposal. These proposed changes include expanding who qualifies as an accredited investor, removing the four-month wait period after a private placement and making it easier for companies to premarket deals.

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