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The small short: big problems brewing on Bay Street

TSX officials seeking solutions to keep troubled venture exchange from sinking
Bayhorse Silver CEO Graeme O’Neill in the offices of his TSX Venture-listed mining company. O’Neill says the venture exchange can be saved if short-selling is banned | chung chow

The TSX Venture Exchange was created to help junior resource companies access public market equity to finance new discoveries.

For a time, it was a great success story. Since its creation, TSX-V-listed companies have raised $100 billion in equity and 600 have graduated to the Toronto Stock Exchange (TSX).

It was particularly good for Vancouver, because about half of the companies that grew up on the small-cap exchange are headquartered here. It fostered a whole ecosystem of supporting businesses: investment brokers, lawyers, accounting firms, geologists, engineering and environmental firms and drilling companies.

But that ecosystem is now suffering the death of a thousand cuts, and the TSX Venture Exchange along with it, according to retail investors and resource newsletter writers.

So when TSX officials convene a town hall meeting in Vancouver on January 28 to discuss a white paper it published before Christmas on fixing the venture exchange, it can expect to get an earful.

The small cap exchange – dominated by junior resource companies – has lost 76% of its value since 2011. That represents an erosion of $50 billion in market capitalization, according to Ivan Lo of Vancouver’s Equedia Investment Research.

As for the TSX itself, Lo said, “Since 2008, it’s been the worst performing major stock exchange in the world.”

There are 1,233 TSX Venture-listed companies that are classified as resource sector companies, according to junior resource analyst John Kaiser of Kaiser Research Online. More than half of them have negative working capital, he says.

While the end of the Chinese super cycle, a plunge in commodity prices and general investor cynicism are major factors, Kaiser and other industry insiders unanimously agree that regulations introduced in Canada by both the TSX and securities regulators have compounded a cyclical crisis with structural impediments.

To hear them tell it, the TSX and securities commissions have been trying to cure anemia with leeches.

Kaiser warns that the structural barriers “threaten the entire resource junior ecosystem with extinction.”

On December 17, the TSX released a white paper outlining its plans to address some of the venture exchange’s problems. One issue it promises to address is the cost of staying listed.

It costs the average venture-listed company between $200,000 and $250,000 annually just to meet its listing requirements. For many juniors, that’s their total cash balance for the year, which means that, by the time they pay the TSX its fees, they have no money left for their core business: drilling holes in the ground.

But Kaiser said the real problem isn’t how much it costs for a company to list on the exchange, but rather the barriers that prevent new investment.

“The real problem is how is the capital flowing into these companies?” Kaiser said.

Graeme O’Neill, CEO of Bayhorse Silver Inc. (TSX-V:BHS), said the TSX’s white paper doesn’t address some of the biggest problems. If it truly wants to save the Canadian junior resource sector, it needs to do one thing, he said: ban short-selling of venture-listed company stock.

That, and scrap accredited investor limits that prevent ordinary citizens from investing, through private placements, in high-risk ventures like mining and oil and gas exploration and development.

“There’s a lot of people who believe shorting shouldn’t be allowed in the junior exchange because it is, by its nature, a highly illiquid market,” O’Neill said. “There’s very little liquidity on the exchange now, so the shorts have a greater effect on small volume than on a significant volume day.”

Some in the investment community believe short-sellers serve a function because their negative votes against companies let other investors know who the dogs are.

But others describe them as vultures that thrive only when things die, so they’re motivated to undermine a company’s stock.

Short-selling runs contrary to the general principle that anyone who owns stock in a company wants it to succeed so their stock will go up.

Short-sellers want the opposite: they benefit from a company’s stock going down. They profit from failure.

In the past, an “uptick” rule prevented short-selling stock that was already dropping. That rule was eliminated in Canada in 2012.

O’Neill and others believe shorting has seriously eroded investor confidence, because it can undermine the confidence in a stock among “long” investors.

Kaiser doesn’t believe short-selling should be banned but he thinks the uptick rule should be reinstated.

One way to reintroduce some much-needed capital into the venture market would be for securities regulators to eliminate the accredited investor rule, which assumes that wealth necessarily equals sophistication.

Anyone can buy existing stock, but only individuals with financial assets of $1 million or net income of at least $200,000 can buy new shares through a private placement, and that severely restricts the ability of junior companies to raise capital.

“That leaves a very large pool of potential placees in the United States, but it badly shrinks the Canadian pool of eligible placees,” Kaiser writes.

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