The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert regarding Rule 105 of Regulation M’s (Rule 105) restrictions on short selling in connection with a public offering. The Risk Alert provides that, since January 2010, the SEC has collected disgorgement, penalties and interest in excess of $42 million based on violations of Rule 105 and has settled over 40 actions in which it found that firms and/or individuals have violated Rule 105. The Risk Alert reminds firms of the need to consider certain control procedures that may improve firms’ compliance with Rule 105 and the consequences of trading activities that fail to comply with Rule 105.

Rule 105 makes it unlawful for a person to purchase securities in a firm commitment equity offering from an underwriter or broker dealer participating in the offering if that person sold short the security that is the subject of the offering during the Rule 105 restricted period, absent an available exception discussed below. The Rule 105 restricted period is typically the period beginning five days before the pricing of the offered securities and ending with such pricing.   

There are three exceptions to the Rule 105 restriction: (i) the bona fide purchase exception, (ii) the separate account exception and (iii) the investment company exception. The bona fide purchase exception generally provides that persons can purchase securities in the offering even if they sell short during the Rule 105 restricted period as long as they make bona fide purchases equivalent in quantity to the amount of the restricted period short sales prior to pricing. The exception for separate accounts generally allows a purchase of the offered securities in an account of a person where such person sold short in another 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. The investment company exception allows a registered fund (or series of such fund) to participate in an offering, even if another series of the registered fund or an affiliated registered fund (or series of such fund) sold short during the Rule 105 restricted period. 

The Risk Alert provides that it is important for firms to provide training to their employees regarding the application of Rule 105, develop and implement policies and procedures reasonably designed to achieve compliance with Rule 105 and enforce those policies and procedures. In determining the penalties associated with the violations in settled Rule 105 enforcement actions, the SEC has considered, among other factors, whether the firms implemented remedial efforts such as developing and implementing policies, procedures and controls to prevent or detect Rule 105 violations. In addition, the SEC’s National Examination Program staff have raised inadequate policies and procedures that fail to identify, mitigate and manage risks involving short sales in connection with follow-on or secondary offerings. The Risk Alert reminds firms that prompt remedial steps to address violations of Rule 105 would not absolve a firm or individual from the violation of Rule 105, and these same remedial steps, had they been proactively implemented, may have prevented the violations. 

Click here to read the Risk Alert.