Regulation by enforcement: who pays the price?

A regulatory investigation is costly, disruptive and time-consuming to its subject and many others who are affected by requests for documents and other evidence. Most investigations are confidential to third parties unless and until the matter is made public by the commencement of a proceeding. Once proceedings are commenced, additional costs, time and public scrutiny are layered on and can last well beyond litigating the matter. An investigation can take years, proceedings (if they follow) can take additional years, and the reputational fall out can endure for years following the proceeding. Regardless of the outcome, these matters can hang over the heads of all those involved for years before any steps are taken to shut the investigation down, or to bring a public enforcement proceeding.

As discussed in our Osler Update entitled, “Water cannot be turned into wine: Cormark and the legality of triangular hedging transactions”, in Cormark Securities Inc. (Re)^[1], the Capital Markets Tribunal (the Tribunal) dismissed all allegations made by the Ontario Securities Commission (Staff or the Commission) against a registered investment dealer and individual respondents. In its statement of allegations, Staff alleged that the respondent firm and individuals used a private holding company to engage in an illegal and abusive short selling scheme involving shares of a publicly-traded cannabis company (the Public Issuer), that violated Ontario securities law and was contrary to the public interest. All allegations brought against the respondents were rejected.

The Tribunal not only rejected Staff’s allegations, but also found that the transactions at issue were carefully crafted to, and did, comply with securities law. This decision is significant not only for the guidance it provides on the legality of triangular hedging transactions, but also because the Tribunal made a point of expressing its dissatisfaction with the wide-ranging and very serious allegations made against the respondents, going so far as to refer to the allegations as an “overreach”. 

The Tribunal’s decision marked the conclusion of an enforcement saga related to transactions that occurred more than seven years earlier. The Tribunal noted that despite the success of the respondents, the unfortunate consequence of the proceeding is that the respondents incurred significant financial and reputational costs defending the allegations, which they cannot recover.^[2]  

The Tribunal’s considered determination

Aside from scrutiny of the specific transactions, in its statement of allegations, Staff also alleged that the firm and individual respondents failed to deal honestly and in good faith with the Public Issuer.

The proceeding was commenced by Staff’s statement of allegations on November 9, 2022, several years after the transactions at issue. Staff’s allegations remained public and were not addressed publicly until the commencement of the hearing on April 11, 2024. The hearing took place over 16 days until June 14, 2024. The Tribunal reserved its judgment for five months, releasing its decision on November 6, 2024.

In rejecting Staff’s allegations, in addition to its finding that the transaction at issue was lawful and not contrary to the public interest, the Tribunal found the Public Issuer was not a client of the firm nor its principals, and any alleged benefits accruing to them were not apparent at all and were “hypothetical” or “minimal”.^[3] The Tribunal concluded that the requirement to deal fairly, honestly and in good faith with a client was not engaged, and that no legal or regulatory obligation was breached. The Tribunal observed that all parties involved were sophisticated, and well-advised by counsel.^[4]

The Tribunal also dismissed Staff’s alternative argument that the respondents’ alleged misleading conduct and concealment of details about the transactions from the Public Issuer engaged the Tribunal’s public interest jurisdiction and warranted an order under section 127(1) of Ontario’s Securities Act.^[5]

Specifically, Staff alleged that the firm and individual respondents were required to fully disclose to the Public Issuer the entire series of transactions so that it could make an informed decision as to whether to participate, including whether the short selling was in the best interest of the company and its shareholders. Staff argued that the respondents misled the Public Issuer about the ordinary course nature of the transactions, lied to the Public Issuer about the short selling, concealed other relevant information, and made misleading statements. The Tribunal concluded that the evidence put forward by Staff did not prove any of the allegations. It found that the matters about which the respondents were alleged to have misled the Public Issuer were largely irrelevant to the Public Issuer, and/or grounded in a failure to disclose a hypothetical.

In relation to these public interest allegations, the Tribunal similarly found that the way in which the respondents structured the transactions did not engage the Tribunal’s public interest jurisdiction, finding that, under the circumstances, the respondents had carefully structured the transactions to ensure they did comply with securities law, and in doing so they had done “nothing wrong.”^[6]

The Tribunal’s rebuke 

The Tribunal dismissed the entirety of Staff’s case and found that Staff failed to prove any of its allegations against any of the respondents. Notably, the Tribunal’s reasons characterized Staff’s various allegations against the respondents as “an overreach”. The reasons read as a whole suggest frustration on the part of the Tribunal with the breadth of the allegations and with Staff’s attempt to find subterfuge in a carefully-structured deal among highly sophisticated, well-advised parties.

The Tribunal observed:

Having found that the Commission has not proven any of its numerous allegations of misleading, dishonest or other wrongful conduct, we conclude that these allegations against the Respondents were an overreach. The unfortunate consequence is that the Respondents have incurred significant costs due to this proceeding, both financial and reputational, which they cannot recover.^[7]

The Tribunal’s observation, while no doubt vindicating to the respondents, was likely cold comfort to the individuals who were accused of participating in an “illegal and abusive short-selling scheme”. If the same result occurred in a civil proceeding, the respondents, as the successful party, would have at least been entitled to costs to account for their financial outlay defending the matter. However, as the Tribunal noted, under the current regulatory enforcement regime, individual respondents, even when they have successfully refuted all allegations publicly made against them, are not entitled to reimbursement of costs, notwithstanding that Ontario legislation permits the Tribunal to award litigation and investigation costs against corporate and individual respondents.

Who should bear the cost of regulators ‘doing business’?

Most capital markets regulators are market-funded, in that they are designed so that regulators’ costs are met through fees charged to market participants. Regulated market participants understand that their fees pay for oversight, compliance and enforcement institutions, as these are key elements of the Commission’s mandate to protect investors and promote market integrity and efficiency of capital markets.

In our view, Staff no doubt should be free to pursue novel and/or difficult cases and test the limits of the technical rules and public interest jurisdiction that make up Ontario securities law, without hindrance. This is a necessary element of a sophisticated and public-minded regulator and, in our view, part of the costs paid by market participants to support it, so long as affected parties have an unfettered and fair opportunity to contest regulatory action and allegations.

At the same time, however, the Cormark decision illustrates the potential unfairness that can occur when such cases are pursued by Staff unsuccessfully at the expense of the respondent. When a matter is investigated and pursued as a proceeding, not only are financial costs at issue, but significant risk and reputational concerns are engaged. This case raises the question: if a regulator pursues a novel case in good faith and loses, shouldn’t all of the costs be borne by the market rather than the vindicated party? Perhaps it is time to revisit the appropriateness of cost award reciprocity in certain circumstances that would permit successful respondents to seek costs to offset the financial burden they have endured. It strikes the authors of this post that, where a case is novel, and where there is divided success or none of the allegations are made out, the Commission should bear the cost of those proceedings, as well as the underlying investigation. Enforcement, like compliance oversight, is an essential role played by securities regulators, and this should be part of the consideration when a regulator presents its budget to the market which, in turn, is asked to fund it through the regulator’s fee rule.

Another question that emerges from the Cormark decision is whether enforcement proceedings lend themselves to be subject to scrutiny of a ‘second set of eyes’ before a proceeding is commenced. Professional regulatory bodies such as the Law Society of Ontario (with its Proceedings Authorization Committee) and CPA Ontario (with its Professional Conduct Committee) require an independent review by a separate body before commencing disciplinary proceedings.^[8] Those bodies can approve the commencement of proceedings or take other steps, such as providing guidance or observations to the subjects of an investigation without the need for a formal proceeding. Similarly, before a decision to commence a criminal proceeding is made, the matter is considered by a prosecutorial body such as the Public Prosecution Service of Canada, which must be satisfied that there is a reasonable prospect of conviction, and who can recommend diversion or other alternative measures to resolve issues.

By contrast, the decision of whether to commence a Tribunal proceeding is entirely in the hands of various levels of Staff of the Commission, who are also charged with authorizing and pursuing the underlying investigation. Regardless of their professionalism and ability to apply a “best interest of investors and capital markets integrity” standard, regulatory leadership may run the risk of being seen as too “invested” in an investigation outcome when it comes time to authorize the commencement of proceedings that raise novel issues. In the U.S., for example, all Securities and Exchange Commission investigations and subsequent proceedings (ordinarily directed to pursue relief from the federal courts) require the authorization of the five-person Commission that is not involved in overseeing either the day-to-day investigation nor the proceedings that may follow.

While it could be desirable for an independent body to act as a ‘second set of eyes’ reviewing Staff’s potential cases before a proceeding is commenced, entrenching such a process into the Canadian regulatory framework would likely be cumbersome and unduly restrictive, and ultimately could inhibit properly exercised discretion. That said, given the enormous cost to all parties of pursuing these proceedings, and the irremediable reputational harm that respondents must suffer, in certain circumstances, it may be worth considering the involvement of an independent advisor or body of advisors to review and give an arms-length risk assessment for certain unique cases before a proceeding is commenced, particularly where cases advance novel and untested positions.

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[1] 2024 ONCMT 26.

[2] 2024 ONCMT 26 at para 192.

[3] 2024 ONCMT 26 at para 98.

[4] 2024 ONCMT 26 at para 96.

[5] R.S.O. 1990, c. S.5, s. 127(1).

[6] 2024 ONCMT 26 at para 177.

[7] 2024 ONCMT 26 at para 192.

[8] For more on this see: Joseph Groia, “OSC home improvements: the pressing need for independent oversight” (April 19, 2024).