United States: A Guide To Regulation M: Regulating Market Activity During A Public Offering

Regulation M is intended to prevent potentially manipulative practices by underwriters, issuers, selling security holders and other participants in securities offerings. Understanding the key aspects of Regulation M is essential to ensure compliance.

Regulation M is designated to strengthen the integrity and fairness of the securities markets by regulating potentially manipulative practices by underwriters, issuers, selling security holders and other participants in securities offerings. Regulation M prohibits these parties from engaging in certain trading activities that could:

• artificially raise the price of a security or
• create a false appearance of active trading in the market by investors.

Regulation M needs to be considered whenever an underwriter, issuer or selling security holder, or one of their affiliates, is purchasing or bidding for outstanding securities fungible with securities being distributed or related securities.

Overview

Regulation M consists of six rules (Rules 100-105) under the Securities Exchange Act of 1934, as amended ("Exchange Act"):

• Rule 100 – defines terms used in the other five rules.
• Rule 101 – regulates bids for and purchases of certain securities by distribution participants (a Regulation M term that includes underwriters) 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.

While Regulation M is intended to prevent potentially manipulative trading conduct, it is a prophylactic rule, meaning that it prohibits conduct whether or not that conduct violates the manipulation or antifraud provisions of the securities laws, such as Section 9(a)(2) of, or Rule 10b-5 under, the Exchange Act. However, Regulation M does not provide a safe harbor from liability under these provisions. Therefore, activities permitted by Regulation M may still violate the manipulation or antifraud provisions of the securities laws if the elements of a violation are present.

Rule 101: Restrictions on Distribution Participants

Rule 101 of Regulation M is a key Rule for underwriters' counsel. To determine what conduct Rule 101 prohibits, counsel should understand certain key concepts, including:

• distributions,
• distribution participants and affiliated purchasers,
• covered securities,
• the restricted period,
• activities prohibited by Rule 101 and
• exceptions to Rule 101.

General Rule

Rule 101 applies in securities distributions. The Rule restricts the activities of distribution participants and affiliated purchasers of a distribution participant. These parties are prohibited from bidding for or purchasing, or attempting to induce any person to bid for or purchase, a covered security.

The restrictions apply during the applicable restricted period for the distribution. However, an exception may apply.

If a distribution participant or an affiliated purchaser of a distribution participant is also the issuer or selling security holder in the distribution, then Rule 102 applies to that person instead of Rule 101. This is significant because Rule 101 is less restrictive than Rule 102 (see below Rule 102: Activities by Issuers and Selling Security Holders).

Distributions

Rule 101 applies only in connection with a distribution, and not ordinary trading transactions. Rule 100 defines distribution as a registered or unregistered offering of securities that is distinguished from ordinary trading transactions by both:

• Its magnitude and
• The presence of special selling efforts and selling methods.

Whether a particular securities transaction is a distribution (as opposed to ordinary trading) is a case-by-case, fact-specific determination. However, distribution is a broad concept and most securities offerings are distributions. The following types of transactions, among others, may be distributions if they meet the magnitude and special selling efforts test:

• SEC-registered offerings, including shelf offerings;
• private placements, including offerings exempt under Regulation D under, and Section 4(a)(2) of, the Securities Act of 1933 (Securities Act);
• resales exempt under Rule 144A under, and Section 4(1½) of, the Securities Act;
• Rule 144 resales;
• exchange offers;
• forced conversions;
• warrant solicitations; and
• at-the-market offerings.

Status Determines the Application of Rules 101 and 102

The following chart shows whether Rule 101 or 102 applies to a person based on its status.

Whether a particular offering is a distribution depends on its magnitude relative to ordinary trading activities and whether special selling efforts are present. In assessing the magnitude of a particular transaction, legal counsel typically looks at how the size of the transaction compares to the securities' typical trading volume. Even if a distribution is being made in ordinary trading transactions, as might be the case in an at-the-market program, the presence of unusual transaction-based compensation could indicate that a distribution is occurring.

In a shelf offering, each takedown is examined individually to determine if it is a distribution. The mere existence of a shelf registration statement in itself does not count as a distribution.

Distribution Participants and Affiliated Purchasers

Rule 101 puts restrictions on the conduct of (1) distribution participants that are not also the issuer or a selling security holder in the relevant distribution and (2) a distribution participant's affiliated purchasers.

Distribution Participants

A party is a distribution participant if the party is:

An underwriter. In the context of Regulation M, an underwriter is any party that has agreed with an issuer or selling security holder to:

• purchase securities for distribution,
• distribute securities for or on behalf of the issuer or a selling security holder or
• manage or supervise a distribution of securities for or on behalf of the issuer or a selling security holder.

A prospective underwriter. A party is considered a prospective underwriter, whether or not the terms and conditions of the underwriting are agreed, if either:

• the party has submitted a bid to participate in a distribution and knows or is reasonably certain that the bid will be accepted; or
• the party has reached or is reasonably certain to reach an understanding with the issuer, a selling security holder or a managing underwriter that the party will become an underwriter.

A broker, dealer or other person who has agreed to participate or is participating in a distribution. This covers non-underwriter members of the selling group for the offering.

Affiliated Purchaser of a Distribution Participant

A party is an affiliated purchaser of a distribution participant if the party is:

An in-concert purchaser. An in-concert purchaser acts in concert, directly or indirectly, with the distribution participant in connection with the purchase or distribution of a covered security.

A controlling purchaser. A controlling purchaser is an affiliate of the distribution participant (which may be a separately identifiable department or division of the distribution participant) that, directly or indirectly, controls the purchase of any covered security by a distribution participant or whose purchases are under common control with the distribution participant. This would cover, for example, an underwriter's parent company.

A securities industry affiliate. A securities industry affiliate is an affiliate of the distribution participant (which may be a separately identifiable department or division of the distribution participant) that:

• regularly purchases securities for its own account or the account of others or
• recommends or has investment discretion on the purchase or sale of securities.

This would cover, for example, an investment advisory subsidiary of the underwriter's parent company.

A securities industry affiliate may be able to take advantage of an exception to the definition of affiliated purchaser if these conditions are met:

• An information barrier is established between the distribution participant and the affiliate.
• The two divisions do not have any common officers or employees (except for clerical-type staff) that direct, effect or recommend transactions in securities.
• During the applicable restricted period, the affiliate does not act as a market maker (other than as a specialist in compliance with the rules of a national securities exchange), or engage, as a broker or dealer, in solicited transactions or proprietary trading in covered securities.

(Rule 100)

Covered Securities

Rule 101 restricts conduct involving only covered securities (see "Prohibited Activities – Securities Deemed Covered Securities"). Rule 100 defines covered securities to include both:

Subject securities. These are the securities that are actually being distributed in the distribution.

Reference securities. This category includes:

• securities into which subject securities may be converted, exchanged or exercised, whether or not immediately (for example, common stock underlying convertible bonds); and
• securities that, under the terms of the subject security, may in whole or in significant part determine the value of the subject security (for example, common stock whose price is tracked by an equity-linked note).

Restricted Period

Rule 101 applies during a restricted period beginning before the pricing of the distribution and ending when the distribution or the party's participation in the distribution ends.

Beginning of Restricted Period

The restricted period begins on the later of the following:

One or five days before pricing. The restricted period generally begins five business days before the pricing date. However, the restricted period begins one business day before the pricing date if:

• the security being distributed has an average daily trading volume ("ADTV") of $100,000 or more; and
• the issuer's equity securities have a public float of $25 million or more.

When the party becomes a distribution participant. This allows a broker-dealer that is not a prospective underwriter to join an underwriting syndicate on the pricing day (during the restricted period) and not have bids or purchases for covered securities that it already has made violate Rule 101.

A business day is the 24-hour period based on the principal market for the securities to be distributed, and includes a complete trading session for that market. For example, if an offering prices at or after the close of trading on Tuesday evening and has a one-day restricted period, the restricted period begins at the close of trading in the principal market on Monday. If the same offering prices during the trading day on Tuesday, the restricted period then begins before the open of trading on Monday morning.

End of Restricted Period

The restricted period ends when a distribution participant's participation in the offering is completed. Participation is considered complete when:

• For members of the underwriting syndicate:
• 1. all of the securities in the offering have been distributed to investors and
  2. any stabilization arrangements and trading restrictions in connection with the distribution have been terminated.
• For any other selling group member, when that member has sold its allotment.

Over-Allotment Options ("Refreshing the Shoe")

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 Rule 100, 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.

Prohibited Activities

Regulation M prohibits (1) bidding for covered securities, (2) purchasing covered securities and (3) attempting to induce any person to bid for or purchase a covered security.

The SEC staff has identified certain activities in the IPO allocation context that are prohibited by Regulation M because they constitute prohibited attempts, during the restricted period, to induce investors to purchase a covered security. In each of these cases, an underwriter's conduct links an investor's IPO allocation to that investor's commitment, promise or understanding to also make aftermarket bids for or purchases of the IPO shares. These prohibited practices include, among others:

• Giving IPO allocations only to investors who agree to also purchase in the secondary market (tie-in agreements).
• Communicating to customers that expressing an interest in buying shares in the immediate aftermarket or immediate aftermarket buying would help them obtain an allocation in a "hot" IPO.
• Asking investors during the restricted period whether, at what price and in what quantity they plan to buy the IPO shares in the secondary market.

Securities Deemed Covered Securities

This table shows the types of securities deemed covered securities based on the security being distributed.

Excepted Securities and Activities

Rule 101 excepts certain types of securities and conduct from the application of the rule.

Security-based Exceptions

Rule 101 will not apply to the distribution if the securities being distributed are:

• Actively traded securities. This includes securities not issued by the distribution participant or any affiliate of the distribution participant that meet both of the following conditions:
• • the security has a worldwide ADTV of at least $1 million and
  • the issuer has outstanding common equity securities with a public float value of at least $150 million.
• Investment grade securities. This includes any nonconvertible debt or nonconvertible preferred security rated investment grade by at least one nationally recognized rating agency. As part of its rulemaking under Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC has proposed amendments to Regulation M that would instead except securities based on liquidity, trading levels and fungibility, evaluated using reasonable factors and verified by an independent third party.
• Other securities. Rule 101 excepts a variety of other types of securities, such as investment grade asset-backed securities and certain government and municipal securities.

Activity-based Exceptions

Under Rule 101, distribution participants and their affiliated purchasers may engage in the following excepted activities during the restricted period:

• Research. Distribution of research that satisfies the conditions of Rule 138 or Rule 139 under the Securities Act is permitted during the restricted period. These rules govern the dissemination of research by a broker-dealer in the context of an offering.
• Transactions in Rule 144A securities. A distribution participant may engage in transactions in Rule 144A-eligible securities (and any reference securities) sold in transactions exempt under Section 4(a)(2) of, or Rule 144A or Regulation D under, the Securities Act only to:
• • qualified institutional buyers (QIBs) or persons reasonably believed to be QIBs or
  • persons not deemed U.S. persons under Regulation S under the Securities Act.
• Unsolicited transactions. Unsolicited brokerage transactions or unsolicited purchases that are not effected from or through a broker or dealer, on a securities exchange, or through an inter-dealer quotation system or electronic communications network, are permitted during the restricted period.
• De minimis transactions. Purchases during the restricted period that total less than 2 percent of the ADTV of the security being purchased are permitted. However, to ensure that this exception is used solely for inadvertent errors, it can be relied on only if the distribution participant maintains and enforces written policies and procedures reasonably designed to achieve compliance with Regulation M.
• NASDAQ passive market making and stabilizing. NASDAQ passive market making that complies with Rule 103 is permitted, as are stabilizing transactions that comply with Rule 104.
• Offers to sell the securities being distributed. Rule 101 excepts offers to sell, and the solicitation of offers to buy, the securities being distributed (including securities acquired in stabilizing), as well as securities offered as principal by the person making the offer or solicitation.
• Miscellaneous transactions. Rule 101 excepts other transactions, including odd-lot transactions, basket transactions and exercises of any option, warrant right or conversion privilege.

Rule 102: Restrictions on Issuers and Selling Security Holders

Rule 102 is the analogue to Rule 101 for issuers, selling security holders and their respective affiliated purchasers. Like Rule 101, Rule 102 applies to securities distributions and prohibits the parties covered from bidding for, purchasing or attempting to induce any person to bid for or purchase a covered security during the applicable restricted period, subject to certain exceptions.

A distribution participant that is also the issuer or a selling security holder must comply with Rule 102 instead of Rule 101. However, a party that is an affiliated purchaser of the issuer or a selling security holder (as opposed to the issuer or a selling security holder itself) that also is a distribution participant has the option of complying with either Rule 102 or the more permissive Rule 101. This generally allows a broker-dealer affiliate of a major financial institution to comply with Rule 101 in a securities offering by its parent company or its other non-broker-dealer subsidiaries.

Key Differences Between Rules 101 and 102

Rule 102 does not include several of the exceptions found in Rule 101. This recognizes that issuers and selling security holders may have a greater incentive to engage in manipulation due to their direct interest in the proceeds of an offering. In addition, they generally are not monitored by self-regulatory organizations (like underwriters are) and generally do not participate in the same types of market activities as underwriters.

Rule 102 is more restrictive than Rule 101. For example:

• Rule 102 does not except research, de minimis transactions and basket transactions.
• Rule 102's exception for actively traded securities covers only actively traded reference securities not issued by the issuer or an affiliate of the issuer. This more limited exception still allows an issuer distributing debt exchangeable for the (actively traded) equity of an unaffiliated issuer to hedge that underlying reference security.

However, Rule 102 allows bids, purchases, or inducements to bid or purchase, that are made under certain plans, including:

• Bonus, profit-sharing, pension, retirement, thrift, savings, incentive, stock purchase, stock option, stock ownership, stock appreciation, dividend reinvestment or similar plans.
• Dividend or interest reinvestment plans or employee benefit plans as defined in Rule 405 under the Securities Act.

The exception for certain plans applies only if the distribution is made either:

• Solely to employees or security holders of an issuer or its subsidiaries or a trustee acting on behalf of these persons.
• To persons other than employees or security holders, if bids for or purchases of securities under the plan are effected solely by an agent independent of the issuer and the securities are from a source other than the issuer or an affiliated purchaser of the issuer (for example, a market purchase by an agent).

As with Rule 101, Rule 102 does not restrict bids, purchases or other prohibited activities for investment grade securities or Rule 144A securities, subject to certain conditions (see Rule 102(b)(7)). Like Rule 101, Rule 102 also does not restrict unsolicited transactions or exercises of options. Rule 102 also tracks Rule 101 by excepting offers to sell, and the solicitation of offers to buy, the securities being distributed. Regulation M does not prohibit an affiliate of the issuer, such as an officer or director, from purchasing securities in an offering.

Rule 105: Short Selling Before a Public Offering

Rule 105 is intended to prevent a manipulative practice in which a party sells a security short just before a public offering and then covers that short position with securities purchased in the offering. This practice is considered manipulative because it can artificially drive down the price of the security, which then reduces the issuer's offering proceeds. At the same time, it provides a profit to the short seller without a corresponding risk because the short seller knows it will be able to cover its short position with securities purchased at the fixed offering price.

Regulation M does not prohibit an affiliate of the issuer, such as an officer or director, from purchasing securities in an offering.

Rule 105 makes it unlawful for anyone to sell short a security that is the subject of a registered offering and then purchase the offered securities from an underwriter, broker or dealer participating in the offering if:

• The offering is a firm commitment equity offering for cash.
• The short sale occurs during a specified pre-pricing period. This period is the shorter of the period starting:
• five business days before the pricing of the offering and ending with the pricing of the offering and
• with the initial filing of the registration statement and ending with the pricing of the offering.

Exceptions to Rule 105

Rule 105 includes several exceptions that allow a short seller to purchase securities in an offering despite having shorted the offered shares during the pre-pricing period. These include exceptions for:

Bona fide purchasers. A party that shorted a stock before it knew about or decided to purchase the stock in an offering can purchase in the offering if it takes certain steps. These steps are designed to ensure that the purchaser is making a bona fide purchase (rather than evading the rule) and that the purchase is reflected in the security's market price. The party has to:

• purchase a number of shares at least as great as the number of shares it shorted, and the purchase must be reported to an effective transaction reporting plan;
• make the purchase after the party's last pre-pricing period short sale and during regular trading hours no later than the business day before pricing; and
• not have effected a short sale reported to an effective transaction reporting plan within the 30 minutes before the close of regular trading on the business day before the day of pricing.

Separate accounts. A party can purchase in a public offering even if it shorted the relevant stock during the pre-pricing period if both:

• the short sale and the offering purchase were made in separate accounts and
• the trading decisions were made separately and without coordination.

Investment companies. A registered investment company can purchase in a public offering even if an affiliated investment company or separate fund shorted the stock during the pre-pricing period. For example, if one fund in a fund complex shorts a stock, this generally does not disqualify all of the other funds in the complex from purchasing in an underwritten offering of the stock.

Bruce Czachor practices in the area of corporate law with a focus on representing investment banks and corporate clients in capital markets transactions, as well as advising clients with respect to securities law matters including general disclosure matters, Sarbanes-Oxley compliance and related corporate governance issues. He also advises clients on mergers and acquisitions.

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

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