In the largest Rule 105 (Short Sale Rule) enforcement case to date, the SEC reached a $7.3 million settlement against Worldwide Capital and its principal last Wednesday, March 5. The SEC's message has been consistent since Mary Jo White became Chair of the agency, and was yet again loud and clear: Rule 105 violations will be hounded.[1]Worldwide Capital, a Long Island-based proprietary trading firm, and Jeffrey Lynn, its founder, agreed to pay disgorgement of $4.2 million in profit and prejudgment interest of over $500,000, in addition to a penalty of $2.5 million. The total settlement amount dwarfed previous settlement figures by alleged Rule 105 offenders. In the past settlements simultaneously reached last Fall, the SEC's largest settlement against one of the violators was just over $3 million. The Worldwide Capital penalty of about one-half the illegal profits is in line with prior settlements.[2]

Rule 105 prohibits short selling an equity security during a restricted period—typically five business days before a public offering—and subsequently purchasing the same security through a follow-on or a secondary offering. Significantly, the Short Sale Rule applies regardless of the trader's intent, though there are exceptions for bona fide purchases, separate accounts and registered investment companies. The Short Sale Rule serves to ensure that offering prices are naturally set by market forces of supply and demand, in lieu of manipulative activity which artificially depresses the market price shortly before the offering.

SEC Chairman Mary Jo White has unequivocally expressed that Rule 105 enforcement remains a priority for the SEC.[3] As noted above, in September of last year, the SEC announced enforcement actions against nearly two dozen stock market participants for alleged violations of Rule 105.[4] Simultaneously, the SEC's National Examination Program issued a risk alert to emphasize risks of non-compliance with Rule 105.[5] At that time, BakerHostetler advised hedge funds, broker-dealers, and other financial firms in an Executive Alert to review their compliance programs and ensure that they meet the requirements of Rule 105.[6]

Since the slew of enforcement actions last fall, the SEC has continued aggressively cracking down on Short Sale Rule violations, announcing actions against Charles Raymond Langston III, and two of his companies, as well as Christopher P.C. Kuchanny and Revelation Capital Management, among others.[7] In commenting on the Worldwide Capital settlement, Andrew M. Calamari, director of the SEC's New York Regional Office stated that, "Rule 105 is an important safeguard designed to protect the market against manipulative trading, and we will continue to aggressively pursue violators."[8]

In bringing action against Worldwide Capital, the SEC alleged that Lynn, his company, and traders acting on their behalf bought securities in follow-on and secondary public offerings after having sold short the same securities during the pre-offering restricted period.[9] By doing so, they improperly benefitted from the difference between the proceeds from their restricted period short sales and the amounts they paid for the same securities acquired in the subsequent public offering. The SEC also alleged that defendants reaped an additional benefit because they bought the offering securities at a discount to the market price of the publicly trading shares. According to the SEC, Lynn and his company participated in 60 public stock offerings covered by Rule 105 after shorting those same securities during the pre-offering restricted period.

Under the settlement terms, Lynn and Worldwide Capital consented to cease and desist from violating Rule 105. Notably, the SEC did not require Lynn or Worldwide Capital to admit any wrongdoing, even though the SEC trumpeted this settlement as being a "record-breaking" Rule 105 penalty. We previously alerted our clients to the SEC's policy change in requiring admissions, when Chairman White stated that admissions of wrongdoing will be sought where the conduct is particularly egregious.[10] At this time, we strongly advise hedge funds, broker-dealers, and other financial institutions including foreign and domestic funds, registered or not, to not only review, but actively monitor and enforce their compliance programs and ensure that they meet all requirements of Rule 105.[11] We note that investment advisers that operate multiple funds or strategies may qualify for a "separate accounts" exception, but must, inter alia, implement certain training, information barriers, and maintain separate profit and loss statements for each account to successfully avail themselves of the exception. In announcing the Worldwide Capital settlement, the SEC specifically noted that Worldwide's use of multiple accounts was not sufficient to shield the firm under the "separate accounts" exception.