Division of Market Regulation:
Staff Legal Bulletin No. 10
Prohibited Solicitations and Tie-in Agreements
for Aftermarket Purchases
Action: Publication of Division of Market Regulation Staff Legal Bulletin.
Date: August 25, 2000.
Summary: This staff legal bulletin (bulletin) sets forth the views of the Division of Market Regulation (Division), reminding underwriters, broker-dealers, and any other person who is participating in a distribution of securities (distribution participants), that they are prohibited from soliciting or requiring their customers to make aftermarket purchases until the distribution is completed.
Supplementary Information: The statements in this bulletin represent the views of the Division's staff. This bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission (Commission). Further, the Commission has neither approved nor disapproved its content.
Contact Persons: For further information, please contact: James Brigagliano, Assistant Director, or Joan Collopy, Special Counsel, in the Office of Trading Practices, Division of Market Regulation, at (202) 942-0772.
1. Solicitations and Tie-in Agreements
for Aftermarket Purchases
Recently, the Division has become aware of complaints that, while participating in a distribution of securities, underwriters and broker-dealers have solicited their customers to make additional purchases of the offered security after trading in the security begins. Moreover, some underwriters have required their customers to agree to buy additional shares in the aftermarket as a condition to being allocated shares in the distribution (i.e., "tie-in" agreements). These practices are prohibited by Rules 101 and 102 of Regulation M,1 and may violate other anti-fraud and anti-manipulation provisions of the federal securities laws.2
2. Regulation M Prohibits Solicitations and
One of the principal purposes of the federal securities laws is to protect the integrity of the process for offering securities to the public. As an anti-manipulation regulation, Regulation M is intended to protect the integrity of the offering process by precluding activities that could artificially influence the market for the offered security. In particular, Regulation M prohibits distribution participants from "directly or indirectly . . . attempt[ing] to induce any person to bid for or purchase" any security that is the subject of a distribution otherwise than in the distribution.3 Thus, solicitations or other inducements by distribution participants during the distribution to generate purchases in the aftermarket are prohibited until the distribution is completed.4
Tie-in agreements are a particularly egregious form of solicited transaction prohibited by Regulation M. As far back as 1961, the Commission addressed reports that certain dealers participating in distributions of new issues had been making allotments to their customers only if such customers agreed to make some comparable purchase in the open market after the issue was initially sold.5 The Commission said that such agreements may violate the anti-manipulative provisions of the Exchange Act, particularly Rule 10b-6 (which was replaced by Rules 101 and 102 of Regulation M) under the Exchange Act, and may violate other provisions of the federal securities laws.6
Solicitations and tie-in agreements for aftermarket purchases are manipulative because they undermine the integrity of the market as an independent pricing mechanism for the offered security.7 Solicitations for aftermarket purchases give purchasers in the offering the impression that there is a scarcity of the offered securities.8 This can stimulate demand and support the pricing of the offering. Moreover, traders in the aftermarket will not know that the aftermarket demand, which may appear to validate the offering price, has been stimulated by the distribution participants. Underwriters have an incentive to artificially influence aftermarket activity because they have underwritten the risk of the offering, and a poor aftermarket performance could result in reputational and subsequent financial loss.9
For these reasons, the Division reminds distribution participants that solicitations and tie-in agreements for aftermarket purchases before a distribution is completed are manipulative sales practices prohibited by Rules 101 and 102 of Regulation M,10and may violate other anti-fraud and anti-manipulation provisions of the federal securities laws.
||17 CFR 242.101 and 242.102. Regulation M applies to a "distribution" of securities, which is defined in 17 CFR 242.100 to mean any offering of securities that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods. This bulletin does not address any other securities laws issues that solicitations and tie-in agreements may raise.
||See Securities Exchange Act Release No. 6536 (April 24, 1961). The Commission also has held that tie-ins are fraudulent devices that violate Section 17(a) of the Securities Act of 1933 (Securities Act) and Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act), and Rule 10b-5 under the Exchange Act, because they facilitate material omissions in connection with the offer or sale of securities. See, e.g., Richard D. Demaio, Initial Decision Release No. 37 (August 4, 1993), Securities Exchange Release No. 33062 (October 15, 1993) (final release) (purchasers of IPO units also required to buy common stock in the immediate aftermarket).
"Purchase" is defined in Section 3 of the Exchange Act to include a contract to purchase, so an accepted solicitation and a tie-in agreement are prohibited purchases even though they are executed later (i.e., when aftermarket trading begins). 15 USC 78c (a) (13).
||Rule 101 of Regulation M applies specifically to underwriters, prospective underwriters, brokers, dealers, or other persons who have agreed to participate or are participating in a distribution of securities. Rule 102 applies to issuers, selling security holders, or any affiliated purchaser of such persons.
||See, e.g., SEC v. Wexler, Securities Exchange Act Release No. 13225 (April 22, 1992), Securities Exchange Release No. 14489 (September 21, 1995); P.N. MacIntyre & Co., Inc., Securities Exchange Act Release No. 10694 (March 20, 1974); S.E.C. v. Burns, 816 F.2d 471, 476-77 (9
th Cir. 1987).
||Securities Exchange Act Release No. 6536 (April 24, 1961).
||Id. In 1974 and 1975, the Commission proposed Rule 10b-20 to ban tie-in agreements (including those discussed in this Bulletin) in connection with an offering of securities. See Securities Exchange Release No. 10636 (February 11, 1974), 39 FR 7806, and Securities Exchange Release No. 11328 (April 2, 1975), 40 FR 16090. Among other things, the proposed rule would have explicitly prohibited broker-dealers (and others) from (explicitly or implicitly) demanding from their customers any payment or consideration (including a requirement to purchase other securities) in addition to the announced offering price of the offered security. This would include, for example, conditioning an allocation of shares in a "hot issue" (for which demand exceeds supply) on an agreement to buy shares in another offering or in the aftermarket of another offering, for which there may be a lack of demand. The proposal was withdrawn in 1988, in part due to the passage of time since proposing, and because the Commission concluded that such agreements may be reached under the existing anti-fraud and anti-manipulation provisions of the federal securities laws. See Securities Exchange Release No. 26182 (October 14, 1988), 53 FR 41206. See also C. James Padgett, 52 SEC 1257 (1997), aff'd sub. nom, Sullivan v. SEC, 159 F.3d 637 (D.C.Cir. 1998). In Padgett, the IPO purchasers were obligated to sell their shares back to the firm at the beginning of aftermarket trading. The Commission determined that this agreement created a materially false impression of the extent of aftermarket activity. As such, the tie-in agreement operated as a fraud upon the market and defrauded aftermarket purchasers in violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act, and Rule 10b-5 under the Exchange Act.
||Regulation M applies to distributions of securities with an existing trading market and to IPOs.
||In Padgett, supra note 6, the Commission noted that tie-in agreements also can increase a firm's control over the supply of a security by ensuring that IPO purchasers will sell their IPO shares back to the firm rather than to the firm's competitors. Control over the supply of the security increases a firm's ability to control the security's price (i.e., such control would enable the firm to artificially inflate both the repurchase and resale prices, creating the appearance of active interest in the issue). In a competitive market, an increased supply of the security could reasonably be expected to lower the security's price.
Tie-in agreements that require purchasers in the distribution to sell their shares back to the firm also raise concerns whether the firm has actually completed its participation in the distribution. The provisions of Regulation M continue to apply until all of the shares have come to rest in the hands of investors. See Securities Exchange Act Release No. 38067 (December 20, 1996), 62 FR 520.
||See Walk-In Medical Centers, Inc. v. Breuer Capital Corp., 818 F.2d 260 (2d Cir. 1987).
||While Rules 101 and 102 contain exceptions for certain activities and types of securities, it is highly unlikely that any of those exceptions would apply to the offerings discussed in this bulletin.