On September 16, 2014, the Securities and Exchange Commission announced enforcement actions against 19 firms and an individual trader for short sales in violation of Rule 105 of Regulation M. The SEC’s latest crackdown on short-selling violations in advance of stock offerings came one day shy of the one-year anniversary of enforcement actions against 23 firms for Rule 105 violations and the issuance of the SEC’s National Examination Program (NEP) Risk Alert highlighting observations on Rule 105 compliance issues. The most recent enforcement actions resulted in the imposition of cease-and-desist orders and more than $9 million in civil penalties, disgorgement and interest.
Rule 105 exists to promote offering prices that are set by natural forces of supply and demand, rather than manipulation, by discouraging short selling that could artificially depress market prices. 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: 1) the period beginning five business days before a public offering and ending with such pricing, or 2) the period beginning with the initial filing of such registration statement or notification on Form 1-A or Form 1-E and ending with the pricing. There is no intent or “scienter” requirement, so this rule applies regardless of whether a trading strategy was intended to manipulate the price of the security. There are, however, three specific exceptions to the rule.
Bona Fide Purchase Exception
An individual can purchase equity securities in the offering regardless of selling short during the restricted period so long as the individual makes a bona fide purchase equivalent in quantity to the amount of the restricted period short sale prior to the pricing. In order to qualify under this exception, individuals must make sure they are in compliance with the specific timing and trade reporting requirements that are in place to ensure that the purchasing activity in the equity security is visible to the market prior to the pricing of the offering.
Separate Accounts Exception
This exception allows a purchase of an offered equity security in an individual’s account in situations where that individual sold short in another account during the restricted period. The SEC has provided several factors to help show that accounts are indeed separate:
- Investment and trading strategies and objectives are separate and distinct.
- Personnel for each account do not coordinate trading among or between the accounts.
- Information barriers separate the accounts, and information about securities positions or investment decisions is not shared between accounts.
- Each account maintains a separate profit-and-loss statement.
- There is no allocation of securities between or among accounts.
- Personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and account owners of multiple accounts, do not have authority to execute trading in individual securities in the accounts and, in fact, do not execute trades in the accounts. Likewise, they do not have the authority to preapprove trading decisions for the accounts and, in fact, do not preapprove trading decision for the accounts.
Investment Company Exception
The third exception permits an individual, registered fund – or a series of such fund − to participate in an offering of an equity security regardless of whether another series of the registered fund or an affiliated registered fund sold short during the restricted period.1
During this most recent announcement, Andrew Ceresney, director of the SEC’s Division of Enforcement, stated:
Rule 105 is an important preventive measure designed to protect issuers from downward pressure on their stock price in advance of offerings. These charges should remind investment advisers and others of the need for robust and comprehensive compliance programs covering Rule 105 compliance.
The announcement also noted that the Enforcement Division’s assistance from the Financial Industry Regulatory Authority (FINRA) helped “to quickly identify potential violations.”
Market participants would be well-served to take notice of the SEC’s continued pursuit of violations of Rule 105 of Regulation M. In this regard, firms and individuals who engage in short-selling activities should familiarize themselves with the guidance set forth in the NEP Risk Alert to ensure that they are in accord with the requirements of Rule 105. Such efforts should include:
- promoting training to employees regarding the application of Rule 105,
- developing and implementing policies and procedures specifically tailored to the particulars of the firm’s business and that are designed to achieve compliance with Rule 105, and
- monitoring and enforcing compliance with those policies and procedures.
1For example, an individual fund within a fund complex is generally not prohibited by Rule 105 from purchasing an offered security if another fund within the same complex (i.e., an affiliate) sold short the same security within the restricted period. Exchange Act Release No. 56206, 72 Fed. Reg. 45,094 (August 10, 2007) at 45,100.