The latest chapter in our Practical Guide to the Regulation of Hedge Fund Trading Activities has been released. Chapter 5: Rule 105 of Regulation M and Tender Offer Rules summarizes how the rule works, along with past enforcement activity, and makes predictions about the SEC's current approach. The ways in which Hedge Fund investments may inadvertently violate Rule 105 are addressed, and what a hedge fund should do if that occurs.
Rule 105 of Regulation M may create more anxiety among compliance professionals in the hedge fund industry than any other SEC rule. It is a "strict liability" regime, meaning that you can be found in violation even if the infraction was an innocent error resulting in little profit. The SEC has historically brought actions based on such errors, and it has methodically brought a series of new actions every couple of years. This article explains the law of Rule 105, and includes some illustrative examples. It summarizes some of the past enforcement activity, and makes some predictions about the SEC's current approach.
Although unrelated to Regulation M, this article ends with a side note on the federal tender offer rules. We do not mean the "large set" tender offer rules under Section 14(d) of the Exchange Act, which apply to a tender for the shares of publicly-listed securities. Rather, we address the "small set" of rules under Section 14(e), which apply to tenders for private company equity. It is these rules that (sometimes rather unpredictably) become relevant to hedge fund transactions.
What ties these two substantively unrelated sets of rules together? Both are notorious for funds unwittingly drifting into technical violations, and both are practice areas where the SEC has been known to proceed based on unintentional, technical violations.
How Does Rule 105 of Regulation M Work?
The SEC adopted Rule 105 to prevent manipulation in the pricing of a firm commitment registered public offering of equity securities. The concern is that short selling just prior to pricing could artificially depress the offering price. Thus, the rule focuses on restricting short selling during a "restricted period" in advance of pricing. More specifically, the rule only applies under the following circumstances:
1. There is a registered offering of securities for cash, meaning a registration statement was filed with the SEC, and the offering was undertaken on a firm commitment basis, so the underwriter is obligated to purchase the entire offering from the issuer;
2. The hedge fund intends to purchase shares from the underwriter or other offering participant; and
3. The hedge fund wishes to engage in a "short sale" in the "restricted period" immediately prior to the pricing of the registered offering. In order to fully understand when Rule 105 applies, it is necessary to understand in more detail the meaning, in this context, of "securities," "short sale," and "restricted period." After briefly summarizing the meaning of these terms, we will provide illustrative scenarios.
Rule 105 Of Regulation M And Tender Offer Rules
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
