On September 17, 2013, the Securities and Exchange Commission (SEC) announced enforcement actions against 23 investment firms for violations of Rule 105 of SEC Regulation M.1 Rule 105 generally prohibits short selling securities during the five-day trading period leading up to the pricing of an offering and purchasing those same securities from an underwriter, broker or dealer participating in that same offering.
Rule 105 originally only prohibited short selling that was “covered” by the securities being offered publicly. In June 2007, however, the SEC adopted amendments to Rule 105 that have since prohibited all short selling prior to a public offering regardless of whether the position is “covered” by the securities being offered publicly or “covered” at all.
Rule 105 is designed to prevent short selling securities as a way of creating downward pressure on the market price of the securities being offered publicly before the issuer prices its public offering. These shorts are viewed as manipulative because they can artificially create value for the investment firm at the expense of the issuer in a public offering.
There are a few exceptions to the short-selling prohibitions in Rule 105, including:
The restriction does not apply to non-firm commitment offerings, and the SEC can also grant exemptive relief.
Rule 105 applies to all short selling activities in violation of the rule regardless of intent. Investment firms should have surveillance systems in place to detect Rule 105 short selling violations and must report suspected violations to the Financial Industry Regulatory Authority (FINRA) on a suspicious activity report (SAR).
Intentional violations aside, there are a handful of ways that an investment firm might potentially violate Rule 105, including “compliance breaks,” a “plow through” and a “short selling restriction failure.”
- A “compliance break” would involve a failure in the investment firm’s surveillance system such that the syndicate desk and compliance personnel did not properly screen for the investment firm’s short selling positions over the past five trading days before agreeing to accept an allocation in the public offering. It is important that trading accounts are properly aggregated to minimize the risk of a compliance break.
- A “plow through” can occur if the syndicate desk and the compliance personnel identified a short selling position but simply did not know or did not care about the Rule 105 prohibition.
- A “short selling restriction failure” can occur when the investment firm knew about the public offering and failed to put the securities on principal trading restriction. Compliance with Rule 105 has become more difficult with the growing prominence of block trades and other overnight and one-day offerings.
Look for the SEC to bundle Rule 105 cases as it continues its enforcement efforts with the assistance of FINRA.
1 A copy of the press release can be found at: http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539804376#.UjhxkNL-N8E.
Brian Korn and Alexander D. Gonzalez