United States: SEC Steps Up Enforcement Efforts Against Illegal Short Selling

On December 3, 2013, the SEC charged a Miami-based trader with illegal short selling ahead of a public offering of securities, in violation of Rule 105 of Regulation M.¹ The action is the latest in a string of enforcement actions this year aimed at preventing price manipulation in advance of stock offerings, as the SEC has directed new attention to combating Rule 105 violations.

I. OVERVIEW OF REGULATION M RULE 105

Rule 105 of Regulation M broadly prohibits the purchase of securities in follow-on and secondary offerings when the purchaser has taken a short position in the securities within a specified restricted period, typically five business days before the pricing of the offering.² The Rule aims to prevent purchasers from artificially depressing market prices of securities ahead of an offering by aggressive short selling.³

Rule 105 is a strict liability rule, and the SEC need not demonstrate manipulative intent or scienter on the part of the purchaser to prove a violation. To comply with the Rule, traders who have sold short shares of a security that are the subject of an offering during the restricted period must refrain from purchasing in the offering, unless one of the limited exceptions to the Rule applies.

a. Scope of the Rule

Rule 105 applies to SEC-registered offerings of equity securities underwritten on a firm commitment basis.⁴ The Rule will not apply to offerings that are exempt from registration, offerings of debt securities, or offerings underwritten on a best efforts basis. Furthermore, the Rule applies only to offerings for cash consideration; exchange offerings, therefore, are not covered by the Rule.

b. Three Limited Exceptions to the Rule

Traders may purchase in an offering covered by the Rule despite having taken a short position in the offered securities during the restricted period in only three circumstances:

• The "bona fide purchase" exception allows purchasers to participate in an offering despite having sold short during the restricted period provided they make a bona fide purchase of the issuer's securities, in a quantity that at least offsets the amount sold short, prior to the pricing of the offering;⁵
• The "separate accounts" exception allows a purchaser to purchase securities in an offering even if the purchaser sold short during the restricted period, provided the short sale was on behalf of a separate account maintained by the purchaser, and trading decisions for the different accounts were made independently;⁶
• The "investment companies" exception permits an investment company registered under Section 8 of the Investment Company Act of 1940 to purchase securities in an offering even if an affiliated investment company or a series of the investment company sold short during the restricted period.⁷

The exceptions to Rule 105 are narrow and highly specific. For example, traders relying on the "bona fide purchase" exception must comply with strict timing rules,⁸ and traders relying on the "separate accounts" exception must consider whether the relevant accounts have distinct trading and investment strategies, whether sufficient information barriers exist between the accounts, and whether personnel with oversight over both accounts have the authority to execute trades or approve trading decisions.⁹ Traders must engage in a thorough analysis of the facts and circumstances surrounding participation in an offering following a short sale to determine the applicability of any exception.

c. Consequences of Rule Violation

Rule 105 is a prophylactic rule, and firms found to have violated the Rule may be subject to a variety of penalties even where the violator acted inadvertently. Violators may be assessed civil penalties, and will likely be required to disgorge any profits obtained as a result of the violation. Furthermore, the SEC regularly publishes administrative orders detailing the violation upon resolution of the case, and a violating firm will be required to disclose any settlement reached with the SEC in its Form ADV.

II. RECENT SURGE IN SEC ENFORCEMENT ACTIONS

In September 2013, the SEC charged over twenty firms with violations of Rule 105, signaling a renewed focus on enforcement. The firms, including private equity firms, hedge funds, and registered broker-dealers, were alleged to have participated in firm commitment offerings after selling short securities that were the subject of the offerings.

The breadth of the SEC's recent actions indicates a strict approach to enforcement of the Rule, without regard to the magnitude of the violation or remedial efforts undertaken by firms following inadvertent violations. In one recent case, the SEC assessed a money management firm a $65,000 penalty, even though the firm realized just $4,091 in profits as a result of the violation, took prompt remedial action, and fully cooperated with the SEC.¹⁰ Another firm was required to disgorge profits of nearly $600,000 and pay a civil penalty of roughly $215,000 despite relying on the advice of outside counsel during its participation in the offering that was the subject of the violation.¹¹ Indeed, a National Exam Program Risk Alert recently issued by the SEC's National Examination Program and Office of Compliance Inspections and Examinations stresses that "[a]fter-the-fact remediation [does] not absolve a firm or individual from the violation of Rule 105."¹²

III. BEST PRACTICES FOR FIRMS TO AVOID RULE 105 VIOLATIONS

Given the strict liability nature of Rule 105 violations and the SEC's disregard of remedial action for purposes of assessing liability, effective compliance policies are paramount to mitigating the risk of inadvertent violations. Any asset management firm or private fund which participates in public offerings, whether or not the firm is registered with the SEC, should review its compliance policies to ensure ongoing compliance with Rule 105.

Firms should develop policies and procedures to ensure that adequate means exist for trading personnel to confirm that no short positions were added during the restricted period prior to participating in an offering. In addition to ensuring adequate policies are in place, thorough training of employees regarding the application of Rule 105 should be the benchmark of any firm's compliance program. Earlier SEC orders have noted that violations are apt to occur where personnel either misunderstand or are unaware of the Rule, and compliance manuals or other firm policies fail to address the Rule.¹³

Although remedial measures taken after a violation may not absolve a firm of liability, compliance policies should nonetheless also specify remedial steps to be taken following a violation, in order to demonstrate to regulators that a comprehensive approach to Rule 105 compliance has been adopted.

Footnotes

1 SEC Press Release, "SEC Charges Miami-Based Trader With Insider Trading and Short Selling Violations," (Dec. 3, 2013), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540433928.

2 17 C.F.R. 242.100(b).

3 For purposes of Rule 105, a "short sale" is defined 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." 17 C.F.R. 242.200(a).

4 17 C.F.R. 242.105(a).

5 17 C.F.R. 242.105(b)(1).

6 17 C.F.R. 242.105(b)(2).

7 17 C.F.R. 242.105(b)(3).

8 For example, the "bona fide" purchases must be effected during regular trading hours and such purchaser must not have effected a short sale of the subject securities within thirty minutes prior to the close of regular trading hours on the business day prior to the day of pricing, among other requirements. See 17 C.F.R. 242.105(b)(1)(i).

9 Exchange Act Rel. No. 56206, 72 F.R. 45,094 (Aug. 10, 2007), at 45,098-45,099.

10 Credentia Group, LLC, Exchange Act Rel. No. 70394 (Sept. 16, 2013).

11 Vollero Beach Capital Partners LLC, Exchange Act Rel. No. 70408 (Sept. 16, 2013).

12 National Exam Program Risk Alert, Sept. 17, 2013, available at http://www.sec.gov/about/offices/ocie/risk-alert-091713-rule105-regm.pdf.

13 See, e.g., Carlson Capital, L.P., Exchange Act Rel. No. 62982 (Sept. 23, 2010).

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