Recently, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued guidance concerning Rule 105 (“Rule 105″) of Regulation M of the Securities Exchange Act of 1934, as amended. Rule 105 prohibits the purchase of securities in a secondary offering if the purchaser has a short position of the same securities established during a specified restricted period. A short sale is defined as the “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.”
The SEC’s guidance and recent cases indicate that the SEC will likely direct its attention to Rule 105 violations in firm examinations and SEC investigations. Issuers should take steps to ensure that their internal policies address Rule 105 compliance.
The SEC’s concern over Regulation M violations is demonstrated by its September 16, 2013, action where it charged over 20 firms with violating of Rule 105 of Regulation M.
About Rule 105
Rule 105 prevents purchasing securities in a firm commitment underwritten offering of shares if the purchase has made a short sale of such security during a restricted period. The restricted period is generally five business days prior to the pricing of the underwritten offering. Rule 105 of Regulation M applies to existing securities offerings by public companies as well as initial public offerings/ IPO’s.
Regulation M is based upon the premise that short selling immediately prior to a public offering dilutes offering prices and impairs the issuer’s capital raising abilities. Since the price of shares in a follow-on or secondary offering is generally set at a discount to the closing price just prior to the offering, Regulation M was necessary to prevent market participants from artificially depressing share prices by aggressively short selling prior to the offering. Under these circumstances, the investor could sell short then purchase shares in the offering at a reduced price to cover their short sales lowering the proceeds
Exceptions to Rule 105 of Regulation M
Rule 105 contains three limited exceptions that allow participation in public offerings after shorting the same securities. These include bona fide purchases, trading in separate accounts, and purchases by registered funds when an affiliated investment company previously shorted the securities subject to the underwritten offering.
Regulation M Enforcement Actions
In September of this year, the SEC charged 20 firms with violations of Regulation M charging that each first shorted during the restricted period and then purchasied these same securities from an underwriter, broker, or dealer through a follow-on public offering, Those charged include registered investment advisors, asset managers, registered broker-dealers, and trading firms.
Firms should provide educational programs regarding Rule 105 to their employees aqnd develop and consistently enforce policies and procedures that prevent Rule 105 violations. If a firm discovers a violation it should immediately take remedial action and cooperate with SEC Staff in any investigation.
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