On August 6, 2007, the Securities and Exchange Commission (the "SEC" or the "Commission") published final amendments that significantly modify Rule 105 of Regulation M under the Securities Exchange Act of 1934 (the "Exchange Act").1 The amendments will become effective on October 9, 2007.
Before its amendment, Rule 105 prohibited a person from covering a short sale with securities purchased from an underwriter or a broker or dealer participating in a firm commitment offering if such short sale occurred during the Rule's restricted period. The language could suggest that some purposeful or intentional activity was required to be shown to prove a violation of the rule. Amended Rule 105 eliminates the covering element.2 Rule 105(a) now simply prohibits a person from purchasing securities from an underwriter or a broker-dealer participating in a firm commitment offering of equity securities if the person sold short the security that is the subject of the offering during the "restricted period" specified in the Rule. The restricted period generally is the five-business-day period before the pricing of the offered securities.
The SEC also clarified that Rule 105 applies only to registered equity offerings for cash made on a firm commitment basis. Therefore, the Rule does not apply to best efforts offerings and most, if not all, Private Investment in Public Equity (PIPE) transactions.
Rule 105 now captures offerings made under Form 1-E, Notification pursuant to Regulation E, by registered small business investment companies or by business development companies registered under the Investment Company Act of 1940 (the "1940 Act"). The Commission stated that application of Rule 105 to Regulation E offerings "is designed to ensure that participants in the secondary market for the securities of small business investment companies and business development companies will enjoy the same protections afforded to participants in the secondary market for the securities of similarly placed non-investment companies."
In response to comments that an absolute prohibition on purchasing a security in a public offering that a person sold short during the Rule 105 restricted period would be unnecessarily restrictive, the Commission included three exceptions to amended Rule 105(a).3
The Bona Fide Purchase Exception
Rule 105(b)(1) permits a restricted-period short seller to purchase offered securities if the short seller makes a bona fide purchase of the same security. Whether a purchase is bona fide depends on the facts and circumstances surrounding the transaction. A transaction made in technical compliance with the exception, but that is part of a scheme or plan to evade the Rule, would not be bona fide. The Release provides as an example of a purchase that is not bona fide a transaction that does not include the economic elements of risk associated with a purchase for value.
To take advantage of the bona fide purchase exception, the short seller must purchase a quantity of shares at least equal to the quantity sold short during the Rule 105 restricted period. Moreover, the bona fide purchase must be made during regular trading hours and reported under an effective transaction reporting plan (defined in SEC Regulation NMS). The purchase must occur no later than the business day before the day of pricing, and must be made after all restricted period short sales were made. Finally, the bona fide purchase exception is not available to persons effecting short sales within the 30 minutes before the close of regular trading hours on the business day before the day of pricing. The last condition reflects the Commission's concern that potentially manipulative activity near the close of trading may put downward pressure on offering prices and possibly reduce the issuer's offering proceeds. It appears, however, that a bona fide purchase may be made at any point during the regular trading hours before the day of pricing of the offering and does not require a full business day separation between the bona fide purchase and the pricing of the offering.
The Separate Accounts Exception
Rule 105(b)(2) provides an exception for persons with separate accounts. A person who has multiple securities accounts may purchase an offered security in one account even if he or she sold the same security short during the Rule 105 restricted period in another, separate account "if decisions regarding securities transactions for each account are made separately and without coordination of trading or cooperation among or between the accounts." This exception is intended to incorporate the principles for independent trading unit aggregation contained in Rule 200(f) of SEC Regulation SHO, which allows broker-dealers to treat noncoordinating trading units separately for short sale purposes. The exception is available to any account manager and is not limited to certain types of persons, such as registered investment companies or registered investment advisers. The SEC reasoned that if decisions regarding securities transactions for each account were made separately, the incentive to manipulate the price of a security would not be present because the short seller could not profit by purchasing discounted offering shares.
Although the Rule's separate accounts criteria are fairly clear, the Commission's release contains an extensive discussion of "indicia" of account separateness. This discussion creates some uncertainty about structures that will qualify as separate accounts. For example, the SEC says that accounts are separate if the following are present: (1) separate and distinct investment and trading strategies for each account; (2) no coordination by personnel of trading among or between accounts; (3) information barriers to separate the accounts; (4) maintenance by each account of a separate profit and loss statement; (5) no allocation of securities between or among accounts; and (6) personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and owners of multiple accounts, who do not have the authority to, and do not, execute trades in the accounts or preapprove trading decisions for the accounts. The SEC also states, however, that these indicia are not exclusive or exhaustive. Even if accounts do not satisfy each of the factors, a person may claim the exception as long as the accounts in fact are separate and operating without coordinating trading. Creation of policies and procedures reasonably designed to maintain separate accounts, coupled with regular review to help ensure effective implementation of those policies and procedures, also would be indications that accounts are separate.
A registered investment company with multiple subadvisers whose activities are subject to supervision by a single, primary investment adviser could take advantage of the separate account exception under certain circumstances. If a subadviser to a registered fund, or a series of that fund, engaged in a short sale during the Rule 105 restricted period while another subadviser to that fund or series purchased the same offered securities, those trading decisions would be viewed as being made separately and without coordination if (1) the subadvisers met the elements of Rule 17a-10(a)(1)-(2) under the 1940 Act, meaning that they acted independently with respect to transactions with the fund, and (2) the primary adviser did not execute trades in individual securities or preapprove trading decisions for the subadvised portions of the fund.
The Investment Company Exception
Rule 105(b)(3) provides an exception for registered investment companies. This exception permits an individual fund that is part of a complex or series to purchase an offered security if another fund within the same complex or a different series of the fund sold the subject security short during the Rule 105 restricted period. In adopting this exception, the Commission reasoned that Section 17(d) of the 1940 Act and Rule 17d-1 thereunder, which generally prohibit an affiliated person of a registered investment company from participating in any joint enterprise or arrangement with the affiliated investment company, would prevent the funds from engaging in the type of coordinated conduct that Rule 105(a) seeks to prohibit.
Rule 105 does not contain a scienter requirement and therefore applies even if the short sale involved in the trading strategy was not effected to manipulate the stock price of the subject securities and even if the short sale was hedged at the time it was effected. Rule 105 could affect trading strategies involving short sales by preventing a variety of persons who effect short sales during the Rule 105 restricted period from purchasing the offered securities. In particular, the Rule will inhibit persons who have sold short a security and then are offered the opportunity to purchase the same security in an "overnight" shelf takedown. Because the restricted period will be five business days before pricing of the offering, the short sale will prevent the seller from purchasing in the offering even though the seller did not (and probably could not) know of the impending offering at the time of the short sale (often referred to as the "gotcha" situation).
Unlike other provisions of Regulation M, amended Rule 105 does not apply to "reference securities." That is, a person may sell short an underlying common equity security and purchase in an offering of a security convertible into the common equity without violating Rule 105. According to the Commission, convertible securities are priced on a number of factors other than the underlying equity's price, making the convertible less susceptible to manipulation through short selling the underlying equity during the prepricing period of the convertible. More generally, the SEC decided that transactions in derivative securities would continue to be beyond the scope of Rule 105. Nevertheless, the Release notes that "the Commission will continue to monitor the use of derivatives strategies that may replicate the economic effect of the activity that Rule 105 is designed to prevent."
Persons who engage in short sales should review and update their policies and procedures to avoid engaging in conduct prohibited by Rule 105. The policies and procedures also should describe activities that fall within the exceptions to the Rule and, specifically, should consider establishing structures and procedures to identify separate accounts.
The SEC may be considering expanding the separate account approach to Regulation SHO, which could broaden the scope of entities and persons who may organize separate trading units to achieve compliance with general short selling requirements. Given the lack of clarity surrounding the separate account exception in Rule 105, however, it may be difficult to implement the approach, absent additional guidance from the SEC.
1 Short Selling in Connection with a Public Offering, Securities Exchange Act Release No. 34-56206, 72 Fed. Reg. 45094 (Aug. 10, 2007) www.sec.gov/ rules/final/2007/34-56206.pdf).
2 17 C.F.R. 242.105.
3 Regardless of whether a purchase is exempt under amended Rule 105 of Regulation M, securities transactions are subject to the antifraud and antimanipulation provisions of the federal securities laws. Moreover, short selling the same securities offered in a registered secondary or follow-on offering may be subject to the registration requirements of Section 5 of the Securities Act of 1933 (the "1933 Act").
Roger D. Blanc is a Partner in the Financial Institutions Regulatory Group of Willkie Farr & Gallagher LLP in the New York office, Larry E. Bergmann is Special Counsel in the Regulatory Group and Matthew B. Comstock is an Associate in the Regulatory Group, both in Willkie Farr's Washington, DC office.