The United States Securities and Exchange Commission (the “Commission”) has stepped up enforcement activities relating to violations of Rule 105 of Regulation M under the Securities Exchange Act of 1934 (“Rule 105”).1 Rule 105 generally prohibits the purchase of a security in certain U.S. public offerings that are registered with the Commission if the purchaser sold short2 the security during the five business days prior to the pricing of the offering. Rule 105 is a “strict liability” rule and applies irrespective of any intent by a short seller to violate Rule 105 (although a lack of such intent may serve as a mitigating factor to reduce the extent of the civil penalty that is imposed). Fund managers should review their compliance policies and procedures to ensure they have mechanisms in place to avoid potential violations of Rule 105 and have communicated the Rule to all personnel.
Rule 105 violations are subject to a five-year statute of limitations, and the Commission is investigating violations that date back as many years.
History and Mechanics of Rule 105
Rule 105 is intended to protect against manipulation of the pricing of public offerings by short sellers (i.e., lowering the offering price to gain an economic benefit) and, thereby, “safeguard the integrity of the capital raising process and protect issuers from manipulative activity that can reduce issuers’ offering proceeds and dilute security holder value.”3
In 2007, the Commission amended the rule, resulting in more inadvertent violations by firms. Prior to the 2007 amendments, Rule 105 prohibited a person who sold short during the five-day restricted period from covering that short sale with securities purchased in a subsequent public offering. Citing abuses of the rule, the 2007 amendments eliminated the covering element of the prior rule. The Commission noted that the 2007 amendments were intended to curb the use of evasive strategies and “sham transactions” that, by hiding prohibited covering transactions, were used to engage in the manipulative behavior that Rule 105 was designed to protect against.
Under the amended Rule 105, a person cannot sell short in the restricted period and purchase securities in the offering, even if the securities purchased in the public offering are not used to cover the short sale. In other words, a person may sell short during the restricted period or purchase securities in the public offering, but he or she may not do both.
The Rule 105 restricted period in most cases begins five business days before the pricing of the public offering, and ends with the pricing of the related offering. The restricted period may be shorter when the issuer is a well-known seasoned issuer (WKSI) utilizing an automatically effective registration statement.
The 2007 amendments also added three limited exceptions to the rule: (1) the bona fide purchase exception, (2) the separate accounts exception, and (3) the registered investment company exception. Under the bona fide purchase exception, a person who sold short during the restricted period may participate in the offering if he or she, after the last short sale was made, covers the total amount of the restricted period short sales at least one business day prior to the pricing of the offering (subject to certain conditions). As such, the bona fide purchase exception may not be available in an “overnight” offering that commences after the close of regular trading on the day of pricing. The separate accounts exception and the registered investment company exception apply in very specific and limited circumstances, and each client should consult its attorney about relevant Rule 105 guidance to ensure that any exception will apply before trading is undertaken. Certain types of offerings are also excepted from the rule, including public offerings that are conducted on a “best efforts” basis.
It is critical to note that Rule 105 is intended to be prophylactic, and no intent is required to prove a violation.
Consequences of a Violation
Any firm that has been found to have violated Rule 105 will be subject to:
- Disgorgement
Disgorgement includes (a) the actual profit as calculated by the difference in share price between the price obtained on short sale and the price paid in the offering (the “short profit”), and (b) the “improper discount” received from purchasing “overage” shares, i.e., the shares improperly bought in the offering at a discount over and above the number of shares sold short, as measured by the closing price or the volume-weighted average price (VWAP) for the day of the offering. - Civil Penalty
A civil penalty is assessed on each violation. Civil penalties vary based on any mitigating or aggravating factors. The amount of civil penalty has been as high as 100% of the disgorgement amount. Published settlements show that civil penalties for violations with mitigating factors were generally 30% to 50% of the disgorgement amount. - Pre-judgment Interest
Pre-judgment interest is also charged, calculated from the date of the violation to the date the matter is resolved. The interest rate is based on the IRS non-payment rate, which varies, but currently is 3%.4 - Public Disclosure
If a Rule 105 case is resolved and not litigated, the Commission publishes an administrative order of settlement. A press release may also be issued.
Recent Commission efforts have identified isolated violations of the Rule where the alleged wrongdoer was unaware of the violations and earned only minimal profits. Indeed, we have observed several recent Commission inquiries concerning inadvertent violations that occurred years in the past. Recent Commission inquiries have also asked firms to examine their trading records and “self-report” any other Rule 105 violations. The Commission has advised that self-reporting a violation may be a mitigating factor in the assessment of the civil penalty.
Illustrative Settlements
A recent administrative order settling a Rule 105 violation illustrates the above points. In In the Matter of JCSD Capital, LLC, the firm settled the cease and desist proceeding for one inadvertent Rule 105 violation. Exch. Act Release No. 67919, Inv. Advisers Act Release No. 3474, Fed. Sec. L. Rep. (CCH) ¶ 80,155 (Sept. 24, 2012). The firm disgorged the $7,062 profit on the shares sold short, as well as the improper benefit ($52,460) it received from the remaining shares it bought in the offering over and above the total shares sold short. The civil penalty was assessed at $29,761, or 50% of the disgorgement amount. This case demonstrates the repercussions of even a small Rule 105 violation – the total assessment was almost $90,000 (including the short sale profit, the “improper benefit” derived from the overage shares it “received at a discount” in the offering), the civil penalty, and the pre-judgment interest) where the profit on the short sale component was just $7,062.
Other administrative orders of settlement also indicate that the separate accounts exception is exceedingly difficult to meet, and hedge funds rarely qualify for the exception because, typically, someone at the hedge fund will have the authority to oversee the separate accounts. That factor alone negates the application of the separate accounts exception. In the Matter of Aristeia Capital, LLC, Exch. Act Release No. 64374, Inv. Advisers Act Release No. 3191, Fed. Sec. L. Rep. (CCH) ¶ 89,431 (May 2, 2011) (separate accounts exception not met where multiple funds with separate strategies; disgorgement was $1,221,571 and civil penalty was $400,000, plus pre-judgment interest); In the Matter of UBS O’Connor, LLC, Exch. Act Release No. 69680, Inv. Advisers Act Release No. 3615, Fed. Sec. L. Rep. (CCH) ¶ 80,309 (June 3, 2013) (Commission rejected reliance on the separate accounts exception to make trades, resulting in 16 violations and disgorgement of $3,787,590, plus a civil penalty of $1,140,000, and pre-judgment interest).
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If you have any questions or concerns about Rule 105, please contact your Seward & Kissel attorney.
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1 17 C.F.R. § 242.105 (2013).
2 For purposes of Rule 105, the Commission defines a “short sale” 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. See 17 C.F.R. § 242.200(a) (2013).
3 See Short Selling in Connection with a Public Offering, Release No. 34-56206, 72 Fed. Reg. 45094 (Aug. 10, 2007) (effective Oct. 9, 2007).
4 I.R.C. §§ 6601, 6621; Rev. Rul. 2013-10 (June 24, 2013).
