A Small Entity Compliance Guide¹

Introduction

The Securities and Exchange Commission adopted amendments to Rule 105 of Regulation M to further safeguard the integrity of the capital raising process and protect issuers from manipulative activity that can reduce issuers' offering proceeds and dilute security holder value. Before Rule 105 was amended, it prohibited a person who sold short during a defined restricted period from covering a short sale² with offering securities. Among other things, the amendments eliminate the covering element of the prior rule because of a proliferation of strategies designed to conceal the prohibited covering and continued violations of the prior rule. The amended rule makes it unlawful for a person to purchase securities in an equity offering if that person sold short the security that is the subject of the offering during the Rule 105 restricted period. Amended Rule 105 also adds three exceptions to the rule concerning bona fide purchases, separate accounts, and investment companies.

Regulation M Rule 105

Amended Rule 105 makes it unlawful for a person who sells short a security that is the subject of an offering to purchase in the offering from an underwriter or broker or dealer participating in the offering if the short sale occurred during the Rule 105 restricted period.³ Generally, the Rule 105 restricted period is the period which begins the five days before the pricing of the offered securities and ends with such pricing.⁴ Alternatively, the restricted period begins with the initial filing of a registration statement or notification on Form 1-A or Form 1-E and ends with the pricing. The rule is designed to prevent manipulative short selling just prior to the pricing of a follow-on or secondary offering and to facilitate pricing based on the natural market forces of supply and demand. Rule 105 is prophylactic. Thus, its provisions apply irrespective of a short seller's intent.

Highlights of the amended rule and release include:

• Changing the prohibited activity from covering to purchasing the offered securities;
• Refining the rule to apply only to "equity " securities;
• Encompassing offerings made pursuant to Form 1-E, Notification under Regulation E; and,
• Clarifying that the rule does not apply to reference securities and thus, in an offering of securities convertible into common equity, a person may sell short the underlying common equity and purchase the convertible securities.

What are the Exceptions to Amended Rule 105?

• Bona Fide Purchase Exception: A restricted period short seller may participate in an offering if there is a "bona fide purchase" of the security that is the subject of the offering prior to pricing.

  • What are the conditions of the exception?

    • The bona fide purchase must be at least equivalent in quantity to the entire amount of the Rule 105 restricted period short sale(s);
    • The bona fide purchase must occur during regular trading hours and be reported to effective transaction reporting plan;
    • The bona fide purchase must be effected after the last Rule 105 restricted period short sale and no later than the business day prior to the day of pricing; and,
    • The person cannot effect a short sale that is reported to an effective transaction reporting plan within the 30 minutes prior to the close of regular trading on the business day prior to the day of pricing.
• Separate Accounts Exception: The exception for separate accounts allows a person to purchase the offered securities in an account where there was a short sale in another related account during the restricted period, if decisions regarding securities transactions for each account are made separately and without any coordination of trading or cooperation among or between the accounts.

  • What are indications of separate accounts?

    • The accounts have separate and distinct investment and trading strategies and objectives;
    • Personnel for each account do not coordinate trading among or between the accounts;
    • Information barriers separate the accounts, and information about securities positions or investment decisions is not shared between accounts;
    • Each account maintains a separate profit and loss statement;
    • There is no allocation of securities between or among accounts; and
    • Personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and account owners of multiple accounts, do not have authority to execute trading in individual securities in the accounts and in fact, do not execute trades in the accounts, and do not have the authority to pre-approve trading decisions for the accounts and in fact, do not pre-approve trading decision for the accounts.

  Depending on the facts and circumstances, accounts not satisfying each of these conditions may nonetheless fall within the exception.

• Investment Companies Exception: An investment company registered under Section 8 of the Investment Company Act or a series of such a company may purchase an offered security where an affiliated investment company or series of such company, or a separate series of the investment company sold short the security that is the subject of the offering during the Rule 105 restricted period. For example, an individual fund within a fund complex is not prohibited from purchasing an offered security if another fund within the same complex (an affiliate) sold short the same security within the restricted period.

Other Resources

The adopting release for the amendments to Rule 105 can be found on the SEC's website at http://www.sec.gov/rules/final/finalarchive/finalarchive2007.shtml.

The proposing release for the amendments to Rule 105 can be found on the SEC's website at http://www.sec.gov/rules/proposed/proposedarchive/proposed2006.shtml.

Contacting the SEC

The SEC's Division of Trading and Markets is happy to assist small companies with questions regarding the obligations of Amended Rule 105 of Regulation M. The Division's Office of Interpretation and Guidance answers questions submitted by telephone at (202) 551-5777 or by email at tradingandmarkets@sec.gov.

¹ This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a "small entity compliance guide" under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended. The guide summarizes and explains a rule adopted by the SEC, but it is not a substitute for any rule itself. Only the rule itself can provide complete and definitive information regarding its requirements.

² Rule 200(a) of Regulation SHO provides that "the term short sale shall mean any sale of a security which the seller does not own or any sale which consummated by the delivery of a security borrowed by, or for the account of, the seller." 17 CFR 242.200. See also Key Points About Reg SHO available at http://www.sec.gov/investor/pubs/regsho.htm.

³ 17 CFR 242.105.

⁴ The Rule 105 restricted period is the shorter of the period:(1) beginning five business days before the pricing of the offered securities and ending with such pricing; or (2) beginning with the initial filing of such registration statement or notification on Form 1-A or Form 1-E and ending with the pricing. Amended Rule 105(a).