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News November 2, 2015 Issue

Rule 105 Dragnet: SEC Snares Six More Advisers, One for the Second Time

It’s round three in the ongoing SEC Rule 105 initiative. With apparent satisfaction that its campaign against advisers that participate in public stock offerings after short selling those same stocks is going well, the agency recently announced six more settlements that brought in more than $2.5 million in fines.

This latest round-up is the third since the initiative began in 2013. That year, the SEC announced actions against 23 firms that brought in more than $14.4 million in monetary sanction (ACA Insight, 9/23/13). In 2014, enforcement actions were brought against 19 firms and one individual trader, netting the agency more than $9 million in fines (ACA Insight, 9/29/14). The agency in 2013 also issued a risk alert against Rule 105 violations.

"This highly successful program of streamlined investigations and resolutions of Rule 105 violations has clearly had an important deterrent impact on the market while expending a fraction of the resources that we have dedicated in the past," said Division of Enforcement director Andrew Ceresney. "We will continue to target important violations that we see repeatedly with multiple actions that send important messages of deterrence."

"Unless we reach a point where the number of violations the SEC finds are de minimis, we’re going to see more of these," said Willkie Farr partner James Burns. Noting that the number of advisers caught in the initiative has dropped each year for the past three years, he said that "when it gets to just one or two, that agency might wait a little longer between announcements, or they might separate announcements for those with egregious violations. At present, though, the SEC has no incentive to turn off the tap."

The SEC staff "has figured out how to crack the egg" in using their analytical software programs to catch perpetrators at low cost, "and they are going to continue doing it," said Mayer Brown attorney Adam Kanter.

What it’s all about

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."

Non-cooperation doesn’t pay off

The SEC made a point of spotlighting one of the six advisers that settled. That adviser also settled Rule 105 violation charges in 2013, but, according to the agency, "refused at that time to review its past trading to determine whether additional violations not identified by the Division of Enforcement had occurred." Unfortunately for the firm, the Enforcement Division "subsequently found seven additional Rule 105 violations," leading to the adviser being sanctioned again, this time with not only a $150,000 civil money penalty but with a conduct order prohibiting it from participating in secondary offerings for a year.

"This is the SEC’s way of saying, ‘If we ask you to cooperate, you should. Come clean now and we’ll include it in the settlement. Anything you don’t tell us will create more problems for you later,’" Kanter said.

"It’s a great example of the risk/reward analysis that a firm must consider when the SEC identifies certain violations, but there are related violations that it is unaware of that a firm must decide whether to disclose or not," he said. "If you disclose, there might be some additional financial penalty, but you are done with the matter. If you don’t disclose, there is no immediate financial penalty for those additional items, but you may pay a higher price later."

How the Rule works

The Rule 105 restricted period – the window when a firm cannot short sell a company’s stock – 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:

  • 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 when another series of the registered fund or an affiliated registered fund sold short during the restricted period.