1. 1 A Survey of Short Sales in Canada Camillo Lento and James Kozyra

2. 2 Reading Questions 1. How does the IIROC’s Universal Market Integrity Rules define short sales in Canada? 2. Is there an uptick rule on short sales in Canada? 3. Are there any restrictions on short sales for insiders in Canada? 4. When does a short sale transaction give rise to taxation consequences in Canada? 5. What elections are available under the Income Tax Act for short sales in Canada? 6. What did the recent IIROC study reveal about the relationship between short sales and liquidity levels? 7. What was the impact of the recent short sale prohibition on price levels on Canada? 8. Did the IIROC identify a relationship between the extent of short sale activity and the extent of market stress? 9. Do short sales have any impact on market quality? 10. What was the average holding period, in days, for short sales?

3. 3 Regulatory Body in Canada In Canada, the Investment Industry Regulatory Organization of Canada (IIROC) governs the most of the activity related to equity short sales through the Universal Market Integrity Rules (UMIR). Part 1 of the UMIR provides the following definition of a short sale: “a sale of a security, other than a derivative instrument, which the seller does not own either directly or through an agent or trustee…” (IIROC, UMIR Part 1, 2010a)

4. 4 The Uptick Rule Uptick rule is currently in effect in Canada:  “Except as otherwise provided, a Participant or Access Person shall not make a short sale of a security on a marketplace unless the price is at or above the last sale price.” (IIROC, UMIR Part 3.1, 2010b)

5. 5 Insiders and Short Sales Some short selling activity is prohibited by certain insiders by the Canada Business Corporations Act (CBCA) :  “An insider shall not knowingly sell, directly or indirectly, a security of a distributing corporation or any of its affiliates if the insider selling the security does not own or has not fully paid for the security to be sold.” (CBCA, 1985)

6. 6 The Taxation of Short Sales Gain or loss is included in income when realized; unrealized gains are not taxed until the transaction is complete Short sale gains are on account of income, not capital;  Election can be made to treat short sale gains on account of income

7. Recent Trends in Canada The IIROC conducted an investigation of trends of short selling for the period of May 1, 2007 to September 30, 2008. Many trends were identified:  Short sales activity was increasing, as the percentage of total trades on the TSX increased from 24% to 26.1% 7

8. 8 Recent Trends in Canada (con’t) Short selling was generally more prominent in newer marketplaces. A negative relationship was found between the level of short sales made on a security, and the level of liquidity of that particular security. Short sales typically have volumes lower than that of the opposing long position in a given security.

9. 9 Short Sales and Market Stress No relationship was found between short sale activity and market stress for the Toronto Stock Exchange (TSX). A more evident pattern was observed for the TSX Venture Exchange measures as the level of short sales and the measure of market stress had a negative relationship.  This relationship held regardless of whether the market was trending up or down.

10. Short Sale Prohibition Recent short sale prohibition, during the credit crisis, on financial stocks led to various impacts on:  Price levels  Market quality  Volume rates 10

11. 11 Conclusion This survey provided insight into:  The regulatory framework of short sales in Canada  The taxation of short sales in Canada  Recent trends on short sales in Canada  The relationship between short sales and market stress  The impact of the short sale prohibition in Canada