Rule 105 Dragnet Snares Another Adviser
The SEC Rule 105 violations locomotive rolls on. The latest adviser to fall under the crackdown’s wheels is an adviser that paid a $65,000 civil money penalty – on allegedly illegal profits of $11,654.
It’s not that the fine the agency on March 19 levied against Keypoint Capital Management, an adviser with more than $244 million in assets under management, is unusually high– the fines meted out by the agency in recent Rule 105 settlements have varied widely, with some higher than the alleged profits involved, others lower – but it is higher than most and does show the continued importance the SEC puts on stamping the violations out.
The past two Septembers, for instance, have been what one might call Rule 105 enforcement months. September 2014 saw the agency settle with 19 advisers, with fines ranging from more than $900,000 to as low as $65,000. In September 2013, the SEC brought Rule 105 violation charges against 23 advisers. Since the agency began its Rule 105 campaign in January 2010, it has charged more than 60 firms. It also issued a risk alert in September 2013 warning of the dangers of violating the Rule.
A high civil money penalty when there is low disgorgement is not that odd, said Shearman & Sterling partner Russell Sacks, because "penalties have generally been rising as a result of a host of factors, including deterrence and the increased resources expended by SEC staff to investigate and pursue matters." Both the SEC and FINRA, he said, have, as a result, shown an inclination to higher penalties in recent years.
Another factor that may influence penalties, according to the risk alert, is whether firms implemented remedial efforts, such as developing and implementing policies, procedures and controls to prevent or detect Rule 105 violations.
The overall crackdown on Rule 105 violations demonstrates that the SEC is using automated processes to match short-sale data with secondary allocation data, said Sacks. "Advisers who engage in short sales and then purchase the same securities in an offering should assume they will receive a phone call from SEC staff asking them to explain it."
Rule 105 of Regulation M prohibits firms from short selling a company’s stock during a restricted period – typically referred to as the five days before a follow-on public offering – and then buying the same security in the offering.
This is because a fundamental goal of Rule 105 is "protecting the independent pricing mechanisms of the securities markets so that offering prices result from the natural forces of supply and demand unencumbered by artificial forces," according to the risk alert. "The Rule is particularly concerned with short selling that could artificially depress market prices. Generally, the offering prices of follow-on and secondary offerings are set at a discount to a stock’s closing price just prior to pricing. A person who expects to receive offering shares may attempt to profit by aggressively short-selling the security just prior to the pricing of the offering, thereby depressing the offering price, and then purchasing lower-priced securities in the offering."
"Rule 105 is an important preventive measure designed to protect issuers from downward pressure on their stock price in advance of offerings," said SEC Division of Enforcement director Andrew Ceresney when he announced the September 2014 settlements.
Keypoint Capital Management
On March 6 and March 7, 2013, Keypoint sold short 24,400 shares of a particular security at prices ranging from $15.90 to $15.94 per share. After the market close on March 12, the pricing of a follow-on offering of seven million shares from the same company was announced, at a price of $15.55 per share. "The Rule 105 restricted period relating to this follow-on offering was March 5 through March 11, 2013, the period beginning five business days before the pricing of [the company’s] offered securities and ending with the pricing of the offering shares," the agency said.
Later that month, Keypoint participated in the follow-on offering and purchased 34,272 of the company’s shares – something it shouldn’t have done, according to the SEC, because it had sold short the 24,400 shares during the restricted period prior to the follow-on offering.
Keypoint, according to the SEC’s administrative order instituting the settlement, made unlawful profits two ways:
From the difference between the proceeds from the restricted period short sales and the amount it paid on an equivalent number of shares from the follow-on offering. These "unlawful profits" totaled approximately $5,380, the agency said.
Where the number of shares Keypoint purchased in the follow-on offering exceeded the number of shares they previously short sold during the restricted period, it "improperly obtained an additional benefit in that they obtained the offering shares at a discount to the market price," the SEC said. This allegedly resulted in unlawful profits of $6,275.
Combined, the unlawful profits Keypoint allegedly made from violating Rule 105 was approximately $11,655, the SEC said. It was ordered to pay back this amount in disgorgement, plus $596 in interest and the $65,000 civil money penalty, for a total penalty of approximately $75,250.
"Keypoint Capital Management takes its obligations to its clients and to the SEC very seriously," said the attorney representing the firm. "In this one instance, the SEC determined that certain equity transactions that resulted in a profit of only $11,655 constituted a technical violation of Rule 105, a rule that is prophylactic in nature and prohibits certain activity irrespective of the seller’s intent. In response, Keypoint acknowledged the activity and offered a settlement to the SEC. Keypoint has subsequently instituted controls to ensure that this kind of inadvertent activity does not recur."
The window and the exceptions
Rule 105 can be somewhat challenging to comply with due to the difficultly in understanding how the restricted window for trading is calculated.
It sounds fairly simple at first. The Rule 105 restricted period is the shorter of either of the following:
The five days before the pricing of the offered securities and ending with the pricing, or
The initial filing of the registration statement or notification on Form 1-A or 1-E and ending with the pricing.
There are three exceptions, however, and they muddy the waters a bit:
Bona fide purchases. This exception allows an entity to purchase a security during an offering even if it sold the security short during the restricted period. Under this exception, the amount of shares purchased must be equal to or greater than the number of shares sold short, the purchase must occur after the short sale but no later than one business day before the pricing of the offering, the purchase must occur before the last 30 minutes of the regular trading session on that day, and it must be properly reported.
Separate account. Under this exception, an entity can purchase an offered security if the same entity sold the same security short in another account during the restricted period. The accounts must be truly separate, "without any coordination of trading or cooperation among or between the accounts," the OCIE risk alert says. The accounts must also have "separate and distinct" investment and trading strategies and objectives; personnel for each account cannot coordinate trading among or between the accounts; each account must maintain a separate profit and loss statement; there can be no allocation of securities between or among accounts; and supervisory personnel over multiple accounts, or account owners of multiple accounts, cannot execute trading in the accounts or pre-approve trading.
Investment company. This 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.
The SEC, when it makes its initial phone calls after identifying potential Rule 105 violators, does not distinguish which firms are working under an exception and which are not, Sacks said, so firms that have established exceptions should be able to explain their compliance with the Rule when questioners ask. Their compliance with an exception should be documented, he said.
The best ways to ensure that your firm stays on the right side of Rule 105 is really no different than staying on top of most rules, said Montgomery McCracken of counsel Terrance Reilly. These include:
Make sure that compliance with Rule 105 is included as part of your compliance policies and your trading procedures. It should state that "if you engage in short sale transactions, there should be a blackout period for those securities that covers the restricted period, as required by Rule 105. If you really want to single out Rule 105, consider naming a Rule 105 point person. This individual would become the answer person on all things Rule 105, including reviewing and updating the policy, answering questions from employees, and more.
Train portfolio managers and others who might be involved with transactions that could trigger the Rule. While you should train employees on compliance with all rules, you might want to call particular attention to Rule 105 compliance, given the SEC’s scrutiny of it. Make a point of training employees on the restricted period during which a transaction can occur and on how to meet the exception requirements.
Monitor for violations. Don’t simply create a policy and not check to ensure it is followed. Instead, consider matching a list of short-sale trades against a list of purchases from offerings and compare the time frames with Rule 105 in mind.