SEC Filed Actions Against 19 Firms and One Individual Trader for Violation of Rule 105 of Regulation M

by Laura Anthony, Esq. on September 23, 2014 in Regulation M, Regulation SHO, Rule 144, Uncategorized

On September 16, 2014, the SEC filed actions against 19 firms and one individual trade for short selling violations in advance of public stock offerings in violation of Rule 105 of Regulation M.  The SEC has actively enforced Regulation M since its enactment in 1996.   Regulation M is designed to prevent stock manipulation during public offerings and Rule 105 particularly prohibits short selling of stock within five business days of participating in an offering for the same stock.  That is, you cannot short stock and cover your short by buying the same stock from the underwriter in a public offering.  Rule 105 prevents downward pressure on a company’s stock price during the offering process.

The SEC’s current investigation found that 19 firms and one individual trader charged in these latest cases engaged in short selling of particular stocks shortly before they bought shares from an underwriter, broker, or dealer participating in a follow-on public offering.  All charged settled with the SEC for a combined $9 million in disgorgement and penalties.

Regulation M

Regulation M was initially adopted in 1996 in an effort to “preclude manipulative conduct by persons with an interest in the outcome of an offering.”  Regulation M prevents underwriters, issuers, selling security holders and other participants in a securities offering from engaging in certain trading activity that could (i) artificially raise the price of a security or (ii) create a false appearance of active trading in the market.

Regulation M is comprised of six rules promulgated under the Securities Exchange Act of 1934, as amended (“Exchange Act”).  In particular:

Rule 100 – defines terms used in the other five rules.

Rule 101 – regulates bids for and purchases of certain securities by distribution participants and some of their affiliates.

Rule 102 – regulates bids for and purchases of certain securities by issuers, selling security holders and certain of their affiliates in connection with a securities distribution.

Rule 103 – allows passive market making on NASDAQ.

Rule 104 – provides a framework for permitted stabilization activities.

Rule 105 – restricts short selling by prospective investors in certain registered offerings.

Regulation M applies to the distribution of securities.  A distribution is not limited to registered offerings.  Rather, a distribution is any offering, whether registered or unregistered, which is larger in magnitude than ordinary trading and selling by that issuer and which involves special selling efforts and selling methods.  Issuers and selling security holders need to carefully consider whether a particular offering invokes the provisions of Regulation M.  In the case of a registered offering, the assumption is that Regulation M applies; however, in a private placement it may not be as clear, especially where it is a private placement limited in distribution but still outside the normal course of business for that issuer.  Moreover, Regulation M may be invoked by large volume resales under Rule 144, the exercise of warrants, forced conversions and exchange offers.

The main operative provisions of Regulation M are Rules 101, 102 and 105.

Rule 101 prohibits offering distribution participants from bidding for or purchasing, or attempting to bid for or purchase or inducing a person to bid for or purchase, a security that is covered by the rule.  The Rule applies to trading in connection with a distribution or offering and not ordinary trading in a security.  Rule 101 prevents manipulative practices from all offering participants other than the issuer or selling security holder in a resale offering.  Offering participants include underwriters, prospective underwriters, brokers, dealers and other persons who have agreed to participate or are participating in the distribution of securities.

Furthermore, the Rule extends to affiliates of offering participants.  An affiliate includes: (i) any person acting in concert, whether directly or indirectly, with the offering participant; (ii) any person that is directly or indirectly under common control of the offering participant; or (iii) a contractual affiliate.

Rule 101 applies during the restricted period beginning before the pricing of the distribution and ending when the distribution or the party’s participation in the distribution ends.  In particular, the restricted period generally begins five business days before the pricing date; however, if any underwriter joins an offering after the 5-day restricted period begins, such underwriter’s restricted period will begin on the day they join the offering.  Generally a distribution is complete, or a party’s participation is complete, when all of the subject securities have been distributed and post-offering stabilization arrangements and trading restrictions have been terminated.

In an equity IPO, underwriters commonly have a net syndicate short position created by over-allotments. This means that the underwriters have agreed to sell more shares to investors than they have committed to buy from the issuer. In these circumstances, the issuer typically grants the underwriters an over-allotment option, which is often referred to as the “greenshoe.” It gives the underwriters the option to purchase additional shares from the issuer at the same price as the other shares purchased in the offering. The underwriters then can use those option shares to cover their short position.

Under Regulation M, a distribution is not deemed complete (and the restricted period is not over) if the underwriters exercise their over-allotment option for more shares than the net syndicate short position at the time the option is exercised. Instead, the distribution is deemed to continue until all of the excess shares have been sold. Any bids, purchases or inducements to purchase that the underwriters made before the exercise could violate Rule 101.

Therefore, the deal team should be aware of the issue referred to as “refreshing the shoe.” Underwriters refresh the shoe by increasing the syndicate short position through additional short sales made after the initial syndicate short position has been reduced (or covered). This practice raises a number of potential regulatory considerations and may warrant discussion with senior members of the deal team.

Rule 101 has several exceptions, including: (i) for the distribution of research reports – i.e., such reports will not be considered inducing the purchase of securities; (ii) transactions under Rule 144A; (iii) unsolicited transactions; (iv) de minimus transactions; and (v) NASDAQ passive market making and stabilization.

Regulation M prohibits offering distribution participants from bidding for or purchasing, or attempting to bid for or purchase or inducing a person to bid for or purchase, a security that is covered by the rule.  The SEC has identified particular underwriter activities that are manipulative and violate Regulation M as inducing a person to bid for or purchase a covered security.  These violating activities include any conduct that could be deemed to request or induce buyers to participate in aftermarket purchases following a distribution.  Examples include: (i) limiting distribution or IPO allocations to investors who agree to purchase in the secondary market (“tie-in arrangements”) and (ii) communicating to potential offering participants that they will be able to participate or have increased participation in a distribution if they agree to buy in the secondary market following the distribution.

Rule 102 applies to the issuer or selling security holder.  Rule 102 is more restrictive than Rule 101 in that it does not include the regular Rule 101 exceptions. Like Rule 101, Rule 102 prohibits offering distribution participants from bidding for or purchasing, or attempting to bid for or purchase or inducing a person to bid for or purchase, a security that is covered by the rule.  Rule 102 does except transaction under certain plans including bonus, profit sharing, pension, stock option, retirement and stock appreciation plans and dividend reinvestment programs.

Rule 105

Rule 105 was adopted by the SEC in 1996 and extensively amended in 2007.  Subject to limited exceptions, Rule 105 makes it unlawful for a person to purchase equity securities in firm commitment public offerings from an underwriter, broker, or dealer participating in the offering if that person sold short the security that is the subject of the offering during the restricted period defined in the rule, absent an exception.  The Rule 105 restricted period is the shorter of the period: (1) beginning five business days before the pricing of the offered securities and ending with such pricing; or (2) beginning with the initial filing of a registration statement or notification on Form 1-A or Form 1-E and ending with the pricing.  In other words, Rule 105 imposes a blanket prohibition on participation in a firm commitment offering by persons who have engaged in a short sale during the five-day period prior to the offering.

Rule 105 specifically prohibits “short selling.”  The Rule incorporates the definition of a short sale from Regulation SHO.  Regulation SHO regulates short sales in general, including locate and close out standards and prohibitions on naked short selling.  A full discussion on Regulation SHO will be included in a future blog.  Regulation SHO defines a “short sale” as “any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.”  Account holders should seek advice from their legal counsel and brokers to avoid an inadvertent violation where such account holder is regularly engaged in short selling practices and option trading.  For example, a short position that existed prior to the regulated 5-day period may experience a stock dividend during the 5-day period which could result in a violation of the rule.

The Rule 105 prohibition only applies to firm commitment underwritten offerings.  A firm commitment underwriting is one where one or more underwriters commit to purchase all of the securities offered by an issuing company, in a particular registered offering, at a negotiated price.  The underwriters then sell or attempt to sell the subject securities to the public at price which is an agreed-upon percent markup from the price the underwriter paid.  The underwriter assumes the risk of a price decrease from the price paid to the issuer and the price in which they are able to resell the securities.  In order to obviate some of this risk, the price paid by the underwriter (and therefore marked-up price that will be paid by the public) is generally not set until the day the offering is to proceed.  One of the many factors in determining an offering price is the trading price for the security where the issuing company is already public.  Rule 105 helps prevent short sellers from driving down the trading price immediately prior to the setting of an offering price.

Rule 105 does not apply to a best efforts offering, which is where one or more underwriters act as placement agent and use their best efforts to place the registered securities to the public in exchange for collecting a commission.

In addition, Rule 105 only applies to “equity securities.”  Accordingly, the rule is not applicable to offerings not involving equity securities, such as debt offerings and derivatives.

The Rule 105 restricted period is the shorter of the period: (1) beginning five business days before the pricing of the offered securities and ending with such pricing; or (2) beginning with the initial filing of a registration statement or notification on Form 1-A or Form 1-E and ending with the pricing.  For purposes of the Rule, a business day includes a 24-hour day, and not just market hours.  Accordingly, where an offering is priced after the market closes, it would still be considered the same business day.  Holidays in which markets are closed are excluded in the 5-days calculation.  Moreover, where the period is being determined by the filing of a registration statement, the relevant period begins with the filing of the initial registration statement, not subsequent amendments.

There are three exceptions to Rule 105, including (i) the bona fide purchaser exception; (ii) an exception for separate accounts; and (iii) for investment companies.

The bona fide purchase exception provides that even if a person has sold short during the Rule 105 restricted period, the person can still participate in the offering if a bona fide purchase of the security effectively reversed the effects of the short sales.  To qualify as a bona fide purchase, the person must show: (i) a purchase of, or purchases that total to, a number of securities at least equal to the number of securities shorted during the restricted period; (ii) the purchase occurred during regular trading hours; (iii) the trades are reported; and (iv) the purchases occurred after all short sales and no later than the business day prior to the day of pricing.  Furthermore, a person relying on the bona fide purchase exception cannot have effected a short sale within the 30 minutes prior to the close of regular trading hours on the business day prior to the day of pricing.  The exception is technical and requires careful evaluation.

The separate account exception permits the purchase of the offered securities if the person sold short during the Rule 105 restricted period in a separate account. A separate account is defined as an account that operates without coordination of trading and coordination among or between the accounts.  Generally speaking, the separate account exception involves managed money accounts, trustee accounts and other situations where the individual account beneficiary is not involved in the trading activity.  The SEC has recognized the following as separate accounts: (i) an account having separate and distinct investment and trading strategies and objectives from the other accounts under management; (ii) personnel for each account do not coordinate trading among or between the accounts; (iii) information barriers separate the accounts, and information about securities positions or investment decisions is not shared between accounts; (iv) each account maintains separate profit and loss statements; (v) there is no allocation of securities between or among accounts; and (vi) persons with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entity do not have authority to execute trades in individual securities of the accounts and do not have the authority to pre-approve trading decisions for the accounts.

The investment company exception allows a registered fund to participate in an offering, even if another series of the registered fund or an affiliated registered fund sold short during the restricted period.

Rule 105 is designed downward pressure on a company’s stock price during the offering process.  In enacting the rule, the SEC indicated concern that traders would short sell securities prior to the pricing of a secondary public offering, forcing down the final offering price and reducing proceeds to an issuer.

A violation of Rule 105 does not include an analysis of intent or knowledge.   Accordingly, any short sale during a registration period should be carefully examined to avoid an inadvertent rule violation.  Even prior to the recent round of enforcement proceedings, the SEC has actively enforced violations of Rule 105.  From January 2010 through September 2013, the SEC collected over $42 million from disgorgement, civil penalties and pre-judgment interest arising from Rule 105 enforcement proceedings.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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