Because this is a frequent enforcement area for the SEC, we are providing this primer on how firms can place functioning controls around their trading to prevent violations of Regulation M, Rule 105 (the “Rule”).
- The Rule:
The Rule prohibits buying securities in secondary offerings when the buyer has executed short sales in the same security within a “Restricted Period” of time prior to the pricing of an offering. The Rule covers:
- Equity securities;
- Purchased from an underwriter or other distribution participant;
- That are offered on a firm-commitment basis; and
- Are a SEC-registered offering for cash or a Regulation A or E offering for cash.
The prohibition is on short sales within the Restricted Period prior to pricing the offering. The Restricted Period is the shorter of:
- The five business days prior to pricing; or
- The time period commencing with the initial filing of the registration statement (registered offerings) or notification (Regulation A or E offerings).
In each case, the Restricted Period ends with the pricing of the offering.
- Key Exceptions:
There are three exceptions to the Rule, two of which are covered below (the third is for registered investment companies).
- Bona Fide Purchase. A short sale during the Restricted Period will not trigger the prohibition if a subsequent bona fide purchase is made. Both the short sale and the bona fide purchase must meet the following criteria:
-Purchase(s) must occur after the last Restricted Period short sale and be at least equivalent to the aggregate amount of Restricted Period short sale(s);
-Purchase(s) must be reported transactions effected during regular trading hours and no later than the end of regular trading on the business day prior to the day of pricing;
-Any of the Restricted Period short sales that were reported transactions must have been effected prior to the last 30 minutes of regular trading on the business day prior to the day of pricing;
-Purchase(s) must be bona fide and not part of a plan or scheme to evade the Rule. For example, a transaction that does not include the economic elements of risk associated with a purchase is not bona fide.
- Separate Accounts. This exception allows a purchase in the secondary offering in one account where a short sale occurred in the Restricted Period in another account for the same person, in limited circumstances. To meet this exception, the decisions regarding transactions for each account must be made separately and without any coordination of trading or cooperation among or between the accounts. This is a facts and circumstances test; the SEC identified the following indicators that may assist in this determination, such as:
-The accounts have separate and distinct investment and trading strategies and objectives;
-Those working on the accounts do not coordinate trading between the accounts;
-Any information barriers that exist and the fact that information about positions or investment decisions is not shared;
-The accounts maintain separate statements, including profit and loss;
-There is no allocation of securities between the accounts;
-Managers of multiple accounts (a single entity or affiliated entities) do not: have authority to and do not in fact execute trading in individual securities in the accounts and do not have the authority to and do not in fact pre-approve trading decisions for the accounts.
- Compliance Tips:
The first step is to develop clear policies and procedures to prevent violations of the Rule, including:
- Specific workflow requiring notification to the Chief Compliance Officer or other responsible person prior to purchasing shares in a secondary offering so s/he can review trading activity to determine whether any short sales took place in the Restricted Period;
- Strict prohibition on participating in the secondary offering if short sales were effected in the Restricted Period, absent full compliance with an exception;
- Plain English descriptions of the securities covered by the rule, the Restricted Period, relevant exceptions and other key terminology; and
- Provisions regarding required documentation to establish exceptions.
Once established, the policy should be distributed to all employees, with in-depth training to those involved in portfolio management and trading. As part of the training, conduct a “dry run” to ensure that the procedures work as intended and that all employees involved in the process understand it.
Documentation will be critical to establish compliance with the Rule. This includes:
- The applicable policies and procedures;
- Evidence that they are being followed, such as logs of subject transactions, any forms completed by traders, e.g., to notify the Chief Compliance Officer, diligence materials regarding any prior short sales, checklists, notes and other real time documentation of compliance with exceptions;
- Evidence of review and testing. At minimum, this should be included in a firm’s annual review. More frequent review and testing may be warranted if this is a high activity area, or for firms that have had prior violations of either the Rule or the procedures required by the policy (even where no violation of the Rule took place).
We have covered the key points of the Rule and its exceptions but we recommend that firms discuss it with their outside counsel and/or compliance consulting firm to answer any questions and ensure that processes are designed appropriately to prevent violations. The penalties for violations are substantial, regardless of whether there was intent to violate the Rule. These include not only disgorgement, interest and monetary penalties, but the publicity involved, disclosures required on Form ADV, among others.
While the staff does take into account remedial efforts by a firm, it believes that efforts should have been made to prevent the violations in the first instance. The SEC’s Risk Alert from September 2013 discusses its examination findings in more detail and is recommended reading.