Speech by SEC Staff:
Remarks Before the SEC Open Meeting: Final Amendments to Rule 105 of Regulation M
Erik R. Sirri
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
June 20, 2007
Good morning Mr. Chairman and Commissioners. The Division of Market Regulation recommends that the Commission adopt amendments to Rule 105 of Regulation M, which concerns short selling in connection with a public offering.
Rule 105 is a prophylactic rule that is intended to foster market integrity and protect the fairness of the capital raising process by addressing potentially manipulative activity that can artificially depress market prices and reduce offering proceeds. The emphasis of the current rule is on covering. Essentially it prohibits a person from covering a short sale with offering securities if the short sale occurred during a defined period (generally five days) prior to pricing.
Summary of Proposed Amendments
To address continuing concerns regarding non-compliance with the rule’s covering prohibition, and in light of the number of enforcement actions brought by the Commission involving strategies designed to conceal Rule 105 violations, in December 2006, the Commission proposed to amend Rule 105 to eliminate its covering element. Instead of prohibiting covering, the proposed amendments would have made it unlawful for a person to effect a short sale during the Rule 105 restricted period and then receive an allocation in the offering.
We received 13 comment letters in response to the proposals. Some commenters were supportive of an absolute ban on purchasing offered securities if a person sold short during the restricted period, several others opposed it, and still others suggested modifications. Commenters generally raised concerns with respect to: (1) the removal of potential investors from the offering pool if they sold short during the restricted period before they became aware of an offering or if they sold short during the restricted period as part of normal trading strategies; and (2) the effect of the proposal on investment companies and investment advisers.
Summary of Recommended Amendments
After consideration of the comments received, and upon thorough examination of current market practices and the purposes underlying Rule 105, we recommend that the Commission adopt a modified version of the proposed amendments to preclude manipulative conduct around the time that an offering is priced.
In particular, the recommended amendments eliminate Rule 105’s covering element. Instead of prohibiting covering, the amendments make it unlawful to purchase in an offering if a person sold short during the restricted period. In response to comments, however, the recommended amendments include an exception for “bona fide pre-pricing purchases” that meet certain requirements. This exception will provide an opportunity for persons to participate in an offering if they sold short during the restricted period prior to becoming aware of an offering and if they sold short during the restricted period as part of their normal trading strategies.
The recommended amendments also include exceptions concerning related but separate accounts and investment companies. The rule is directed against persons who sell short into an offering because they have a high expectation of receiving discounted offering shares. These persons have a heightened incentive to sell short to affect the price of the offered securities that they intended to purchase in order to lock in a profit. However, if the account that sells short during the restricted period is not coordinating its trading activity with the account that purchases in the offering, the motivation to affect price is not present. Accordingly, we recommend exceptions for such situations.
In particular, the recommended amendments include an exception for investment companies registered under Section 8 of the Investment Company Act of 1940. By way of example, the exception would allow such investment company to participate in an offering if an affiliated investment company or any series of such company sold short during the restricted period.
The amendments also include a similar exception for other types of separate accounts. This exception provides that a person can purchase the offered securities in an account if there was a short sale in a separate but related account if decisions regarding securities transactions for each account are made separately and without any coordination of trading among or between the accounts.
The amendments also refine the current rule to explicitly state that it applies only to offerings of equity securities and to short sales of securities that are the subject of the distribution.
We believe the recommended amendments provide a brighter line for compliance that will better protect issuers and the integrity of the U.S. capital raising process. We also believe the amendments will put an end to schemes designed to camouflage the prohibited covering under the current rule.
We therefore recommend that the Commission issue a release adopting amendments to Rule 105 of Regulation M.
I would like to thank Jamie Brigagliano, Josephine Tao, Joan Collopy, Lillian Hagen, Elizabeth Sandoe, and Victoria Crane for their work on this rule. I also would like to thank Janice Mitnick, David Dimitrious, and Lori Price in the Offices of General Counsel, Chester Spatt, Amy Edwards, Stewart Mayhew, and Kathleen Hanley in the Office of Economic Analysis, Lori Richards in the Office of Compliance Inspections and Examinations, Toni Chion, Chris Conte, and Lisa Deitch in the Division of Enforcement, Amy Starr and Heather Maples in the Division of Corporation Finance, and Doug Scheidt and Eric Purple in the Division of Investment Management for their contributions to the release and for making this rulemaking a productive and collegial experience.
We are happy to answer your questions. Thank you.