United States: SEC Alters The Rule On Short Selling In Connection With A Public Offering

This article first appeared on Portfolio Media’s Securities Law360.com, August 31, 2007.

The Securities and Exchange Commission (SEC) has adopted amendments to Regulation M ("Anti-manipulation Rules Concerning Securities Offerings") that prohibit any person who sells short an equity security that is the subject of a public offering from purchasing the offered securities from an underwriter or broker or dealer participating in the offering.

The SEC takes the position that pricing integrity is essential to the capital-raising process in a properly functioning market. The fundamental purpose of Regulation M (Reg M) is to protect the pricing mechanism of the securities markets so that the prices at which securities are offered to the public are a function of supply and demand rather than manipulative activity that can reduce an issuer’s offering proceeds and dilute value to securityholders.

Rule 105 ("the former rule") of Reg M, governs short selling in public offerings. The former rule, which the SEC is amending effective October 9, 2007, prohibits "covering" short sales (purchasing securities to close an open short position) that are made during a defined restricted period with securities purchased in a public offering (offered securities). Thus the former rule made it illegal for a person to cover a short sale with offered securities purchased from an underwriter or a participating broker or dealer during the shorter of (1) the period starting five business days before the pricing of the securities and ending on the pricing date, and (2) the period beginning with the initial filing of the registration statement and ending on the pricing date.

In the proposing release for the Reg M amendments, the SEC noted that there have been continued violations of the former rule, including "a proliferation of trading strategies and structures attempting to accomplish the economic equivalent of the [prohibited covering] activity that the rule seeks to prevent." The SEC therefore proposed amendments to Reg M to eliminate the covering prohibition in order to put an end to trading strategies that obfuscate violations of the former rule.

Under amended Rule 105 ("the new rule"), the prohibited activity is purchasing in the public offering, rather than on covering. Although the proposed amendments imposed an absolute prohibition against purchasing offered securities in firm commitment offerings by a person who effected a restricted period short sale, the final amendments include a "bona fide purchase" exception as well as "separate account" and "investment company" exceptions in response to various comments received by the SEC.

Reg M Amendments

The amendments have been tailored by the SEC to further the primary aim of Reg M, which is to protect the integrity of the capital-raising process. Specifically, the new rule, by eliminating the covering element of the former rule, discourages the use of trading strategies that were designed to conceal the covering of restricted period short sales with offered securities.

Because securities that are sold in follow-on and secondary public offerings are typically priced at a discount to a stock’s trading price in the market, investors have been motivated to capture that discount by aggressively short selling a security just before pricing and then covering those sales at the lower offering prices. Prohibiting an investor from purchasing in the public offering, rather than covering, reduces an investor’s incentive to sell short before pricing in anticipation of the discount and thereby should draw a clearer line with respect to prohibited conduct under Reg M.

Bona Fide Purchase Exception

In response to comments on the proposed rule amendments, the SEC added a provision to the new rule that permits restricted period short sellers to purchase offered securities if they make one or more "bona fide purchases" before pricing. This exception – whose purpose is to protect against manipulative activity without unduly restricting capital formation – allows a person to purchase an offered security if the person sells short during the restricted period but purchases an equivalent amount of the security before the offering is priced. Thus, for example, a trader who had no knowledge of a public offering at the time of the short sale could still participate in the offering by complying with the new rule.

In order to qualify for the exception, the new rule requires that there be a bona fide purchase of the security to cover the short sale before the pricing of the offered security. Whether a particular purchase is a bona fide purchase or a sham transaction would depend, for example, on whether the transaction includes the economic elements of risk associated with a purchase for value. In addition, the covering purchase must be at least equivalent in amount to the entire amount of the restricted period short sale. So, for example, purchasing 50 shares of common stock to cover a short sale of 100 shares during the Rule 105 restricted period would violate the new rule.

The bone fide purchase exception also requires that the covering purchase be made during regular trading hours and reported under an effective reporting plan so that the purchase is transparent to the market. Of course, the purchase must be made after the last restricted period short sale but before the offering is priced. A purchase made before the last short sale during the restricted period would not qualify because it is unlikely to relieve the downward price pressure caused by short selling.

A bona fide purchase must be made at least one business day before the pricing of the public offering so that the market can react to the purchase before pricing. The exception would therefore not be available for a purchase that is made during regular trading hours if the offering is priced after the close of regular trading on the same day. Also, the exception would be unavailable to a person who executes a restricted period short sale within the 30 minutes before the close of regular trading hours on the business day before the day of pricing.

The bona fide purchase exception is available to any person who meets the requirements of the new rule. The provision would, for example, be available to a person who sold short during a Rule 105 restricted period on a Wednesday and again on a Thursday, and then made covering bona fide purchases on Thursday before a pricing on Friday. Likewise, a person could make a number of restricted period short sales and bona fide purchases as long as the purchases (1) aggregated to an equivalent amount of the securities that were subject to short sales and (2) were completed no later than the trading day before the pricing of the public offering.

Separate Accounts Exception

Several commentators on the proposed rule amendments observed that as a result of using the term "person" in the new rule, each fund of a series fund or subdivided portion of a single fund might be prohibited from purchasing offered securities if another fund in the same series or in the same complex sold short during the restricted period, even if those funds were trading independently. The commentators also expressed concern about possible violation of the new rule by a subadviser to a portion of a fund who purchases offered securities after another subadviser to a different portion of the same fund sold short during the restricted period even if the subadvisers were not coordinating their trades.

In response to these comments, the SEC opted, in the new rule, to treat funds within a fund complex, different series of funds and separate subadvised portions of a fund as independent persons for purposes of Rule 105, provided that decisions regarding securities trading for each account are made separately and without coordination or cooperation among or between the accounts. In these instances the SEC believes that there is no incentive to violate the new rule because the short seller cannot capture the offering discount by purchasing the discounted offering shares.

For purposes of determining whether accounts are separate and operating without coordination, the SEC will examine whether

• the personnel coordinate trading among accounts;

• there are information barriers between the accounts;

• information about securities positions is shared between accounts;

• each account has a separate income statement;

• there is any allocation of securities between accounts; and

• personnel with managerial responsibility over multiple accounts have authority to execute trades or preapprove trading decisions for the accounts.

To qualify for the exception, funds should have policies in place that implement the above safeguards. However, accounts that fail to satisfy each of the conditions may still qualify for the exception if they, in fact, are separate and operate without coordination. Thus, for example, a hedge fund that invests in several unaffiliated funds that do not coordinate their trading activity would not violate Rule 105 if one of those unaffiliated funds sold short securities during a restricted period and another unaffiliated fund purchased securities in a subsequent offering. Regular reviews are advisable, according to the SEC, to assure that the policies are current and are followed.

Registered Investment Company Exception

Provisions of the Investment Company Act of 1940 prohibit concerted action between funds in a complex of funds and between series of the same fund. In recognition of this prohibition and various comments on the proposed amendments, the SEC included an exception for an individual fund that purchases an offered security if another fund within the same complex or a different series of the fund sold short during the Rule 105 restricted period. The rationale for the exclusion is that since the fund or account that sells short during the restricted period is prohibited from coordinated action within the fund or account that purchases in the offering, there is no economic incentive for manipulation because no profit can be derived from the transaction.

Other Amendments To Rule 105

The new rule refines the scope of the prohibition by restricting its application to offerings of equity securities for cash. Although the SEC states that it will monitor whether trading patterns in debt securities raise manipulative concerns relating to public debt offerings, for now they are not covered by the new rule. This appears to be an accommodation to commentators who observed that debt securities trade primarily on the basis of yield and credit rating, and are priced on factors such as interest rates, thus making them less susceptible to manipulation.

Rule 105 has also been amended to include the term "subject security," which is included in Reg M Rule 100’s definition of "covered security." The amended rule states that it is unlawful for a person to sell short the security that is the subject of the offering. A person may therefore sell short underlying common equity and purchase a security that is convertible into the common equity in a public offering without violating Rule 105. For the time being, the SEC has accepted the argument that convertible offerings should be excluded from the scope of the new rule because they are priced on many factors in addition to the price of the underlying equity security. However, the SEC said that it will monitor the convertible offering market and may reevaluate whether this should be included at a later date.

By eliminating the covering component and expanding the prohibition to all non-exempt purchases of offered securities, amended Rule 105 should eliminate the proliferation of obfuscating trading strategies that were designed to hide prohibited covering activity. The new rule thus supports the twin goals of protecting independent pricing of equity securities in a public offering and bolstering investor confidence in the proper functioning of the capital markets.