Securities Regulation Update

Transcription

1 September2013 The SEC Settles Multiple Proceedings in Rule 105 Enforcement Sweep On September 17, 2013, the SEC published orders instituting 23 separate enforcement proceedings alleging violations of Rule 105 of Regulation M under the Securities Exchange Act of 1934 (the Exchange Act ), 1 and settling 22 of those 23 proceedings. The SEC s actions appear to be the result of a sweep that its Division of Enforcement undertook of buy-side market participants with respect to Rule 105 compliance. It is unclear whether further actions related to the sweep will be forthcoming. The settlements (the Settlements ), in aggregate, resulted in more than $14.4 million in sanctions levied against the entities involved. 2 On the same date, the SEC s Office of Compliance Inspections and Examinations ( OCIE ) issued a National Exam Program Risk Alert on Rule 105 (the Alert ). 3 The Alert outlines the requirements of Rule 105, including the exceptions to the rule, and stresses the need for robust Rule 105 compliance procedures and enforcement of those procedures. In Appendix B to the Alert, the SEC states that since January 2010, it has settled over 40 actions based on violations of Rule 105, and has collected monetary sanctions totaling more than $42 million. The Alert also contains a list of many of the Rule 105 enforcement proceedings that the SEC has instituted, including the 23 discussed in this memorandum. Rule 105 and Exceptions to the Rule Rule 105(a) generally prohibits a person from purchasing equity securities from an underwriter or a broker-dealer participating in a firm commitment offering for cash if the person sold short the security that is the subject of the offering during the applicable Rule 105 restricted period. The Rule 105 restricted period is the shorter of the period beginning (1) five business days before the pricing of the offered securities and ending with such pricing, or (2) with the initial filing of the registration statement or notification on Form 1-A or Form 1-E and ending with the pricing. Rule 105 contains three exceptions. Rule 105(b)(1) permits a person who sold a security short during the Rule 105 restricted period to purchase the same security in a public offering if the short seller has made a bona fide purchase of the same security. The bona fide purchase exception is available only if (1) the short seller purchases shares in a quantity at least equal to the quantity sold short during the Rule 105 restricted period; (2) the purchases are made during regular trading hours and reported under an effective transaction reporting plan, i.e., to the tape; (3) the purchases are made no later than the business day before the day of pricing; and (4) the short seller does not effect any short sales after the purchase or within the 30 minutes before the close of regular trading hours on the business day before the day of pricing. Rule 105 also contains a separate account exception where decisions regarding securities transactions for each account are made separately and without coordination of trading or cooperation among or between the accounts. Rule 105 additionally excepts certain trading by 1 17 CFR (2013). 2 See SEC Charges 23 Firms With Short Selling Violations in Crackdown on Potential Manipulation in Advance of Stock Offering, SEC Press Release (Sept. 17, 2013), available here. Total monetary sanctions assessed for the Settlements ranged from a low of $69, to a high of $3,180, National Exam Program Risk Alert, Rule 105 of Regulation M: Short Selling in Connection with a Public Offering (Sept. 17, 2013), available here.

2 registered investment companies. Trading that does not violate the requirements of Rule 105, but is effected to manipulate the market, may nevertheless run afoul of anti-manipulation or anti-fraud rules. Observations About the Settlements The monetary sanctions contained in the Settlements include both disgorgement and civil penalties, together with prejudgment interest. The SEC apparently employed multiple theories of disgorgement that encompassed both profitable and unprofitable trades. Disgorgement. First, the SEC calculated disgorgement as the difference between the proceeds of the Rule 105 restricted period short sales, based on the average Rule 105 restricted period sale price, and the price paid for shares received in the offering, up to the number of shares sold short. Example: Investor sold short 50,000 shares of XYZ Corp stock at an average Rule 105 restricted period sale price of $13 per share. Investor then purchased 30,000 shares of XYZ Corp stock in a follow-on offering at $10 per share, in violation of Rule 105. The SEC would require Investor to disgorge $3 x 30,000 shares, or $90,000. The SEC required short sellers to pay disgorgement even if the price of the stock purchased in a follow-on offering was higher than the average Rule 105 restricted period short sale price. In this scenario, the SEC viewed the short seller as having improperly obtained a discount from the stock s market price and avoided losses by purchasing in the follow-on offering. The SEC looked to the market price following pricing of the follow-on offering to determine the improper discount. Example: Investor sold short 30,000 shares of XYZ Corp stock at an average Rule 105 restricted period sale price of $13 per share. Investor then purchased 30,000 shares of XYZ Corp stock in a follow-on offering that priced at $13.50 per share, in violation of Rule 105. The relevant market price of XYZ Corp stock after pricing of the follow-on offering was $14 per share. The SEC would require Investor to disgorge $0.50 x 30,000 shares, or $15,000. The $0.50 represents that discount to market price that Investor obtained by improperly participating in the follow-on offering. Second, if the short seller purchased more shares of stock in the follow-on offering than it sold short during the Rule 105 restricted period, and the shares were purchased in the follow-on offering at a discount to the market price of the shares, the SEC viewed the short seller as having obtained an improper benefit with respect to the number of shares purchased in the follow-on offering in excess of the number of shares sold short. The SEC looked to the market price following pricing of the follow-on offering to determine the improper benefit. Example: Investor sold short 30,000 shares of XYZ Corp stock at an average Rule 105 restricted period sale price of $13 per share. Investor then purchased 50,000 shares of XYZ Corp stock in a follow-on offering at $10 per share, in violation of Rule 105. The market price of XYZ Corp stock at the relevant time after the follow-on offering priced was $12 per share. With respect to the stock sold short, the SEC would require Investor to disgorge $3 x 30,000 shares, or $90,000, the difference between the short sale price and the offering price. The SEC would also require Investor to disgorge the improper benefit $2 x 20,000 shares, or $40,000, where the $2 represents the discount to market September 2013 Page 2

3 Penalties. price the Investor obtained by improperly purchasing shares of stock in the follow-on offering. The SEC generally imposed penalties in the range of 40 to 50 percent of the disgorgement amount, although the Settlements suggest that the SEC set a minimum penalty amount of $65,000 to be imposed on disgorgement amounts of less than $130,000. None of the Settlements involved a penalty of less than $65,000, even though disgorgement amounts were as low as $4,000. The SEC did not explain its rationale for arriving at any of the penalty amounts, but it did note in each Settlement that in determining to settle with a given respondent, the SEC considered remedial acts that the respondent undertook promptly, as well as the respondent s cooperation with the SEC staff with respect to the proceeding. Consideration of the Settlements in Light of the Requirements of Rule 105 Some of respondents to the Settlements may have miscalculated the Rule 105 restricted period. Certain of the alleged violations involved short sales that were effected six or seven calendar days before the pricing of the follow-on offering, but that the SEC viewed as having been effected during the Rule 105 restricted period. The Rule 105 restricted period commences up to five business days before pricing of the follow-on offering and ends with such pricing. Example: A follow-on offering of XYZ Corp prices after market close on Thursday (assume the registration statement was filed several weeks before pricing). The Rule 105 restricted period would run from Thursday back five business days, which would be Monday through Thursday of the week of pricing, plus the preceding Friday. Thus, the restricted period would encompass five business days, but seven calendar days. The SEC staff takes the position, moreover, that the Rule 105 restricted period includes the day of pricing only if the pricing occurs after market close on that day. That is, the Rule 105 restricted period must include complete trading days. Example: A follow-on offering of XYZ Corp prices during regular trading hours, i.e., before market close, on Thursday (assume the registration statement was filed several weeks before pricing). The Rule 105 restricted period would not include Thursday because the restricted period must include five full business days before the day of pricing. In this case, the restricted period would be from Wednesday back five business days, which would be Monday through Wednesday of the week of pricing, plus the preceding Thursday and Friday. Thus, any short sales that occurred after market close on Wednesday of the week preceding the week of pricing would have been effected during the Rule 105 restricted period. The large number of short sales cited in the settlement as occurring the day before the announcement of the offering suggests that certain respondents may not have been aware that certain overnight deals are no longer exempted from the Rule. A prior version of Rule 105 contained a shelf takedown exemption that has been eliminated. While in rare circumstances, an offering prices on the same day that its registration statement is filed and becomes effective, and so would not prohibit a person who sold the securities that are the subject of the offering the day before pricing from participating in the offering, in most circumstances, an overnight September 2013 Page 3

4 deal is a shelf takedown which prohibits participation by persons who have sold short within five business days before the pricing of the offering. The SEC also may have rejected claims that respondents utilized the bona fide purchase exception to Rule 105. As discussed above, a person can effect a bona fide purchase of the securities that it sold short during the Rule 105 restricted period if it effects the purchase no later than the business day prior to pricing and complies with other specified requirements. Although not in the plain language of the rule, the SEC staff apparently takes the position that the bona fide purchase must be effected a full trading day before pricing, as opposed to merely during regular trading hours on the day before pricing. A number of respondents effected short sales on the day before pricing. While the settlements do not provide a full recitation of the respondents trading, if those respondents made purchases intended to be bona fide purchases, but did not do so a full trading day before pricing, the SEC likely took the position that the exception was not available. 4 Example: Investor sells short 1000 shares of XYZ Corp stock on Wednesday, its only Rule 105 restricted period short sales, then learns that a follow-on offering of such stock will price on Thursday. Investor purchases 1000 shares of stock before market close on Wednesday (the stock is reported to an effective transaction reporting plan), intending to take advantage of the bona fide purchase exception so that it can participate in the follow-on offering. The follow-on offering of XYZ Corp stock prices at 1 p.m. on Thursday. The bona fide purchase exception is not available to Investor under the SEC staff s interpretation of business day. Although the purchase was effected on the day before pricing, a full trading day did not elapse between the purchase and pricing because pricing occurred during regular trading hours. Investor would have been required to effect the purchase during regular trading hours on Tuesday to take advantage of the exception, which would not have been possible because it sold short on Wednesday. As noted, the bona fide purchase must be effected after the last Rule 105 restricted period short sale. As discussed above, Rule 105(b)(1)(i)(D) requires that the bona fide purchase be [e]ffected after the last Rule 105 restricted period short sale. The staff of the SEC s Division of Trading and Markets apparently has interpreted paragraph (b)(1)(i)(d) as requiring that the purchase of the entire short sale amount be effected after the last Rule 105 restricted period short sale, although that interpretation does not appear to be published anywhere. Example: A follow-on offering of XYZ Corp stock is set to price after market close on Friday. Investor sells short 300 shares of XYZ Corp stock on Monday, during the Rule 105 restricted period. On Tuesday, it purchases 300 shares of XYZ Corp stock during regular trading hours. On Wednesday, Investor sells short 50 shares of XYZ Corp stock during regular trading hours. The SEC staff would take position that the bona fide purchase exception is available in this case only if Investor purchases, no later than the business day before pricing of the follow-on offering, i.e., during regular trading hours 4 The bona fide purchase exception would never be available to a person who sells short the security that is the subject of a follow-on offering on the day of pricing of such offering. Any such purchase must be effected on the business day before pricing, as discussed. September 2013 Page 4

5 on Thursday, at least 350 shares of XYZ Corp stock. A purchase of 50 shares would not be sufficient. To be bona fide under the SEC s staff s interpretation, the entire purchase of XYZ Stock must be effected after the last Rule 105 restricted period short sale and, in this case, the purchase of 300 shares of stock on Tuesday after the short sale of the same number of shares on Monday would be disregarded for purposes of the exception. To discuss these matters further, please contact any of the following Murphy & McGonigle lawyers: Lindi Beaudreault lbeaudreault@mmlawus.com Larry Bergmann lbergmann@mmlawus.com Matthew Comstock mcomstock@mmlawus.com William Donnelly wdonnelly@mmlawus.com Andrew Beresin aberesin@mmlawus.com For more information about our firm or our regulatory practice, please visit our website at Murphy & McGonigle PC. Murphy &McGonigle is providing this communication solely for educational and informational purposes, and receipt of this publication does not create an attorney-client relationship. The distribution of this publication does not constitute an offer by Murphy & McGonigle or the attorneys listed above to provide legal advice or other service. This publication is not intended to and does not provide legal or other advice.to comply with IRS regulations, we advise you that any discussion of Federal tax issues in this publication was not intended or written to be used, and cannot be used by you, (i) to avoid any penalties imposed under the Internal Revenue Code or (ii) to promote, market or recommend to another party any transaction or matter addressed herein. September 2013 Page 5