In August 2013, we wrote a memorandum to clients and other friends highlighting how important it is for hedge fund managers to understand Rule 105, the provision of Regulation M prohibiting an investor from purchasing shares in a public offering if the investor has shorted during a specified pre-offering period.1 Our memorandum was prompted in part by our awareness that the SEC’s Division of Enforcement was exhibiting renewed interest in fund managers’ compliance with Rule 105, including by means of a market sweep conducted earlier in the year.

As if on cue, on September 17, the SEC announced an unprecedented set of simultaneous enforcement actions alleging Rule 105 violations on the part of 23 firms, including several hedge fund managers.2 All but one of the actions have been settled, resulting in more than $14.4 million in total monetary sanctions. In conjunction with the enforcement announcement, the SEC’s National Examination Program issued a Risk Alert emphasizing the need for fund managers’ compliance programs to address Rule 105.3

The September enforcement actions are significant in several respects. First, they show that the SEC thinks Rule 105 compliance is a big, ongoing problem—the SEC believes the investment community is chronically ignoring Rule 105 and needs to be dramatically reminded of its requirements. Second, the SEC appears to have adopted a programmatic, scalable approach to Rule 105 enforcement. The 22 sparely worded settlement orders are largely formulaic in content and tone, and we can expect to see many more of them if market participants do not remediate their practices. Third, the orders reinforce the fact that even small-dollar violations of Rule 105 are susceptible to SEC attack—willful violators will be caught and punished, but “foot-faults” are also fair enforcement game. Lastly, the orders suggest that investors whose behavior the SEC finds especially troublesome are likely to receive fines that are higher as a percentage of disgorgeable trading profits.

In this update to our August memorandum, we highlight key takeaways from the SEC’s September enforcement actions and related Risk Alert.

A REMINDER OF WHAT RULE 105 PROHIBITS

Rule 105 is part of Regulation M promulgated under Section 10(b) of the Securities Exchange Act. It is thus an anti-fraud provision under the federal securities laws. The goal of Rule 105 is to “promote [public equity] offering prices that are based upon open market prices determined by supply and demand rather than artificial forces.”4

To achieve that goal, Rule 105 generally prohibits an investor from purchasing equity securities from an underwriter, broker or dealer participating in a registered underwritten follow-on or secondary offering if the investor has shorted securities of the offered class during a pre-offering restricted period. The restricted period is the shorter of: (i) the period beginning five business days before the pricing of the offering and ending with the pricing; and (ii) the period beginning with the initial filing of the registration statement for the offering and ending with the pricing. An investor can violate Rule 105 without manipulative or fraudulent intent.5

TAKEAWAYS FROM THE SEPTEMBER ENFORCEMENT ACTIONS AND RISK ALERT

The following are key takeaways from the September enforcement actions and Risk Alert:

  1. The SEC has no tolerance for Rule 105 violations and is committed to enforcing the rule on a large scale. As if the sheer number of September enforcement actions didn’t make the point, the SEC took pains to state publicly that it truly means business on Rule 105. The Press Release indicates “zero tolerance for any securities law violations, including violations that do not require manipulative intent.”6 It is equally clear that the SEC enforcement staff has embraced a no-frills approach to detecting and sanctioning Rule 105 misconduct. The Press Release advises that the staff has adopted a “new program of streamlined investigations and resolutions of Rule 105 violations” designed to “send the clear message that firms must pay the price for violations while also conserving agency resources.”7
  2. A lack of bad intent is no excuse; nor is the small size of a violation. Rule 105 has no scienter requirement. A fund manager can violate Rule 105 without even realizing the rule was in play at the time a fund purchased equity securities in a followon or secondary offering. Each of the September settlement orders contains this sentence: “Rule 105 is prophylactic and prohibits the conduct irrespective of the short seller’s intent in effecting the short sale.” Moreover, the SEC is willing to go after small-dollar infractions. While some of the settlement orders allege illegal profits of more than $1 million, five of the settled actions and the one being litigated each relate to alleged gains of less than $50,000.
  3. It’s hard to predict how much a Rule 105 violation will cost you. But count on particularly objectionable conduct attracting a large fine, and don’t be surprised if small profits are outweighed by the fine. The September settlement orders feature a wide spectrum of disgorged profits and penalties. In the eight orders levying the minimum penalty of $65,000, the disgorgeable profits varied from $4,091 to $137,524. In the remaining 14 orders, the penalty ranged from 20% to 106% of the disgorged amount, with a cluster of six cases around 50%.  

Given the orders’ silence on how penalties were calculated, it is difficult to discern any definite overarching relationship between illegal trading profits and the size of penalty imposed. That said, it appears reasonable to infer from the varying penalty-to-disgorgement ratios that in some cases the SEC took particular issue with the investor’s behavior—perhaps due to repeat violations, a poor compliance environment or lack of cooperation with the staff’s investigation. It also seems fair to conclude that in cases where illicit profits are small, the SEC will not hesitate to impose a penalty that is some multiple of the required disgorgement.

  1. Expect SEC exam staff to scrutinize your trading records for Rule 105 compliance. The issuance of the Risk Alert in conjunction with the enforcement announcements indicates growing collaboration between the SEC’s enforcement and investment adviser exam staffs in rooting out and sanctioning Rule 105 violations. The Press Release highlights “coordination between the enforcement and examination programs” on Rule 105 matters.
  2. Your compliance program must specifically address Rule 105. The Risk Alert notes that “[r]ecent NEP examinations have observed deficient practices relating to Rule 105,” citing in this connection a settled enforcement action in which the SEC alleged that a “firm’s investment personnel either misunderstood or were unaware of Rule 105’s requirements, the firm’s compliance manual did not address it, and the firm lacked policies and procedures sufficient to prevent violations.”8 The Risk Alert further reminds market participants that “it is important to provide training to employees regarding the application of the Rule, develop and implement policies and procedures reasonably designed to achieve compliance with the Rule, and enforce those policies and procedures.”9

SPECIFIC COMPLIANCE SUGGESTIONS

As we noted in our August memorandum, an effective Rule 105 compliance effort boils down to internal education and preventive systems. A hedge fund manager engaged in short selling should consider the following actions, if the manager has not already taken them:

  • Formally recognize the importance of Rule 105 in your compliance program.
    • Adopt, implement and maintain written compliance policies and procedures reasonably designed to prevent violations of Rule 105. 
    • Break out Rule 105 as a separate topic in your policies and procedures. Don’t bury it in a more general anti-fraud or antimanipulation section.
    • Annually review and assess the effectiveness of your Rule 105 policies and procedures.
  • Provide regular Rule 105 training to relevant personnel.
    • Arrange regular training on Rule 105 to all new and existing portfolio managers, analysts, traders and others who participate in or supervise trades involving short sales and public equity investments.
    • If your firm intends to rely on the separate accounts exception to Rule 105, make sure your training focuses on the requirements of the exception, including in particular the need for a viable and respected information barrier between funds or accounts.
    • Consider distributing periodic e-mail reminders about Rule 105 to relevant firm personnel. 
  • Establish a Rule 105 pre-clearance process.

Establish a pre-clearance process that is activated whenever a portfolio manager requests an allocation of equity securities in a public offering. The process would be designed to achieve the following:

  • Ascertaining whether the offering is of a type subject to Rule 105.10 
  • If the offering is subject to Rule 105, calculating the restricted period; determining whether and to what extent the fund has shorted the relevant security during the restricted period; and, if short sales have been made, determining whether the fund is eligible to purchase in the offering in reliance on the bona fide purchase or the separate accounts exception.
  • Do back-testing. Consider running periodic backtests to confirm that your pre-clearance process is working as intended.  

CONCLUSION

The SEC has made abundantly clear that Rule 105 compliance is not a back-burner topic. Fund managers that short and purchase equity securities with any regularity should make a new—or renewed—effort to understand the rule and develop policies and procedures designed to avoid violating it.