Yesterday, the Securities and Exchange Commission (SEC) announced enforcement actions against 23 investment firms for violations of Rule 105 of Regulation M (“Rule 105″) in an effort to crack down on the potential manipulation of offering prices of follow-on and secondary offerings. Twenty-two of the actions settled, resulting in more than $14 million in sanctions. The enforcement actions follow a recent increase in investigations into potential violations of Rule 105 and a request for information earlier this year to a number of hedge fund managers related to such potential violations. Since 2010, the SEC has collected disgorgement, penalties and interest of more than $42 million based on Rule 105 violations.

Along with the enforcement actions, the SEC’s National Examination Program (NEP) issued a Risk Alert highlighting observations on Rule 105 compliance issues, as well as proactive corrective actions to remedy concerns. The co-director of the SEC’s Division of Enforcement, Andrew Ceresney, added the following comments regarding the Rule 105 enforcement actions:

“The benchmark of an effective enforcement program is zero tolerance for any securities law violations, including violations that do not require manipulative intent. Through this new program of streamlined investigations and resolutions of Rule 105 violations, we are sending the clear message that firms must pay the price for violations while also conserving agency resources.”

Given these streamlined enforcement actions and recent comments from the Division of Enforcement, firms would be well-served to review their compliance programs, with a particular focus on Rule 105 compliance.

Background

Rule 105 generally prohibits the purchasing of securities in follow-on and secondary offerings from an underwriter or broker-dealer participating in the offering when the purchaser has conducted short sales in the securities within a specified time period before the pricing of the offering. This “restricted period” is the shorter of the period: 1) beginning five business days before a public offering and ending with such pricing; or 2) beginning with the initial filing of such registration statement or notification on Form 1-A or Form 1-E and ending with the pricing. The goal of Rule 105 is to promote offering prices that are set by natural forces of supply and demand rather than manipulation, seeking to prohibit short selling that could artificially depress the market price.

Because Rule 105 does not require intent by the short seller, a prohibited transaction occurs when a person short sells a security that is the subject of an offering during the restricted period and then purchases shares of that security in the offering.[1] 

Compliance, Penalties and Remediation

In light of these enforcement actions and the SEC’s comments reflecting a hardline stance on Rule 105 violations, it would be wise to heed the NEP’s suggestions that:

  • Firms should promote training to their employees regarding the application of Rule 105;
  • Develop and implement policies and procedures designed to achieve compliance with Rule 105; and
  • Enforce those policies and procedures set in place. 

The NEP noted factors that the SEC considers when determining penalties associated with a settlement for Rule 105 enforcement actions, such as whether the firm implemented remedial efforts, including developing and implementing policies, procedures and controls to detect or prevent Rule 105 violations. The NEP, however, is quick to point out that “after-the-fact remediation” does not absolve a firm or individual from a Rule 105 violation. 

Conclusion

We can take from the above-mentioned SEC actions that it is important for investment advisers, investment companies and broker-dealers to review their compliance programs to ensure that the proper steps are followed in conducting short selling activities in connection with a public offering.

[1] Note that there are three exceptions to Rule 105: 1) bona fide purchases; 2) separate accounts exception; and 3) investment company exception. These exceptions are rather specific so one should seek expert analysis in order to ensure compliance.