On January 26th, the Securities and Exchange Commission (the “SEC”) published a proposal (the “Proposal”) to amend Rule 10b-18 (“Rule 10b-18,” the “Rule,” or the “safe harbor”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).1
Issuers purchase their securities for any number of reasons, such as reducing the number of shares outstanding or to have shares available for dividend reinvestment or stock ownership plans. However, because an issuer also may have an interest in raising the price of its stock, for example, to increase its value as consideration for an acquisition or to create the appearance of the issuer’s strength, repurchases could expose an issuer to claims of manipulation, even when there is a legitimate purpose behind them.
Rule 10b-18 provides a “safe harbor” from claims of manipulation when issuers repurchase their common stock in compliance with certain conditions designed to reduce the market impact of those purchases. These conditions relate to the manner, timing, price, and volume of the purchases. While issuers are not required to effect purchases of their stock pursuant to the Rule, and the Rule states specifically that there is no presumption that bids or purchases that do not comply with the Rule’s conditions violate the anti-fraud provisions of the Exchange Act, many issuers rely on the Rule whenever they purchase their own stock in the open market.2
Of course, there have been significant changes to the market since the Rule was adopted in 1982. Today’s markets are much faster and the volume of trading is significantly higher. “Flickering quotes”3 make it difficult for issuers to ensure that every purchase effected during the day will meet the Rule’s price condition — a significant problem since failure to satisfy any of the Rule’s four conditions on any single transaction during a particular day disqualifies all of the issuer’s purchases for that day from the Rule’s protection. Moreover, the Rule does not permit the use of common strategies, such as volume-weighted average price (“VWAP”) trading, even though they create little risk of the kind of manipulation that the Rule is designed to address.
Proposed Changes to the Rule 10b-18 Conditions
To come within the safe harbor, each one of an issuer’s purchases must satisfy the Rule’s manner of purchase, timing, price, and volume conditions. The SEC is proposing a number of changes to those conditions to align it with the current trading environment.
A. Manner of Purchase
The manner of purchase condition requires an issuer to use only one broker or dealer per day to bid for or purchase its common stock. This is intended to eliminate the appearance of widespread trading in a security that could result from many broker-dealers effecting purchases on the same day. The Proposal does not include any changes to this condition.
The timing condition restricts when an issuer may bid for or purchase its common stock. Currently, the Rule prohibits an issuer from effecting the opening purchase reported in the consolidated trade reporting system.4 It also prohibits purchases during the last half-hour before the scheduled close of the primary trading session in the principal market for the security, and in the market where the actual purchase is effected. (If the security is an “actively traded security,”5 this window is reduced to 10 minutes before the scheduled close). The opening transaction limitation was imposed because the opening price can be a significant indicator of the direction of trading, strength of demand, and current market value of a security, and the limit is a way to prevent issuers from artificially affecting that information. The end-of-day limit is designed to prevent the issuer from creating or sustaining a price trend at or near the close of trading.
The SEC proposes to prohibit issuers from effecting the opening purchase in the principal market for the security, and in the market where the purchase is effected if it is not the principal market, as well as in the consolidated system. That way, if there is a delay in the opening of the principal market, and the security opens first in another market, the issuer will have to wait until both trades are reported before it can effect its first purchase, making it unable to impact the opening price on the principal market. Moreover, the SEC believes that a larger opening transaction in the principal market could be a better indicator of trading direction, strength of demand, and market value of a security than a smaller exchange’s opening trade reported in the consolidated system.
The SEC seeks comment on a number of issues, including whether the end-of-day limitation also should be revised, and whether repurchases of OTC Bulletin Board and Pink Sheet securities, which currently are not subject to opening purchase timing restrictions, should be so restricted.
The price condition is intended to prevent issuers from leading the market upward for their securities by limiting the price at which they may bid for or purchase their securities to a price no higher than the highest independent bid or last reported independent transaction (whichever is higher) in the consolidated system. For securities not quoted or reported in the consolidated system, the issuer must look to the higher of the highest independent bid or the last independent transaction price displayed and disseminated on an exchange or inter-dealer quotation system.
1. VWAP Transactions
In a VWAP transaction, the price of the security is determined by adding the dollar amounts for each transaction (price x shares) and dividing by the total number of shares traded for the day. Because the price is based on numerous individually reported transactions effected throughout the day, the price of the issuer’s VWAP purchase at the end of that day could exceed the highest independent bid or last independent transaction price at the time of execution. Issuers thus cannot effect repurchase transactions on a VWAP basis unless they forego the protection of the safe harbor. In 2003, the SEC proposed excepting from the price condition VWAP and other transactions where the issuer has no control over the price; however, it did not do so. The SEC now proposes to permit Rule 10b-18 purchases on a VWAP basis, provided that:
- the security is an actively-traded security;
- the VWAP purchase order is entered before the open of regular trading, and the execution price is determined based on a full trading day’s volume;
- the issuer complies with all other conditions of Rule 10b-18;
- the VWAP purchase does not exceed 10 percent of the security’s ADTV, and is not effected for the purpose of affecting the price of the security;
- the VWAP is based on trades that satisfy the Rule’s timing and price conditions; and
- the purchase is reported using a special trade modifier.6
According to the Proposing Release, the SEC believes that VWAP transactions meeting the proposed conditions would have little potential for manipulative abuse. The SEC asks a number of questions with regard to the proposed VWAP exception, including whether the exception should be modified in any way, whether the proposed criteria are appropriate, whether trades based on other indicators such as intra-day VWAP or a time-weighted average price also should be excepted, and whether the standard for defining “actively traded” securities is appropriate.
2. Other Passive Pricing Systems
The SEC also is considering an exemption from the price condition for other passive pricing mechanisms, such as purchases through trading systems using passive or independently derived pricing mechanisms, e.g., the midpoint between the national best bid and offer. Under the Rule, execution of such an order would necessarily be above the highest bid price and could be above the last reported sale price, putting the trade outside the Rule. The SEC asks whether it should except from the price condition repurchases through systems that match and execute trades at independently-derived prices, provided that: (i) matches occur at externally derived prices within the existing market and above the current national best bid; (ii) sellers and purchasers don’t know if or when a match will occur; (iii) persons relying on the exception are not represented in the primary market offer or otherwise influencing the primary market bid or offer at the time of the transaction; (iv) transactions are not made for the purpose of manipulating the price of any security; (v) the security is an actively traded security; and (vi) there is no solicitation of customer orders, or communication with customers that the match has not yet occurred, during the period in which the system may match buying and selling interest.
Noting that such trades, unlike VWAP trades, are not reported using any special modifier, the SEC asks what additional safeguards would be necessary to address concerns that such orders could be used by issuers to raise the price of the security. The SEC also asks whether other conditions should be imposed, and whether there are other types of benchmark or derivatively priced transactions that should be excepted from the Rule 10b-18 price condition.
3. “Flickering Quotes”
According to the SEC, the speed of today’s markets, and resulting flickering quotes, make it increasingly difficult for issuers to ensure that every purchase will meet the Rule’s price condition. Moreover, if an issuer inadvertently effects a Rule 10b-18 purchase outside of the price condition, due solely to a flickering bid price, the Rule’s general disqualification provision would cause the issuer to lose the safe harbor for all of its purchases that day.
The SEC therefore proposes to limit the disqualification provision where a repurchase order is entered in accordance with the Rule’s conditions but fails to satisfy the price condition solely due to flickering quotes. In such case, only the noncompliant purchase, rather than all of the issuer’s Rule 10b-18 purchases for that day, would be disqualified from the safe harbor.
D. Volume Condition
The current Rule also limits the amount of securities that an issuer may repurchase in a single day, to prevent an issuer from misleading investors with respect to the amount of interest in the security. Currently, an issuer may effect daily purchases totaling up to 25 percent of the ADTV for its shares. In addition, once each week an issuer may purchase a single block of its stock in lieu of purchasing under the 25 percent volume limit for that day.7 Rule 10b-18(a)(5) currently defines a “block” as a quantity of stock that either: (i) has a price of $200,000 or more; (ii) is at least 5,000 shares and has a price of at least $50,000; or (iii) is at least 20 round lots of the security and totals 150 percent or more of the “trading volume” for that security or, if “trading volume” is unavailable, is at least 20 round lots of the security that totals at least one-tenth of one percent of the outstanding shares of the security (exclusive of shares owned by affiliates).
The SEC proposes to amend the foregoing references to “trading volume” to “ADTV,” in order to make the definition consistent with the Rule, and asks whether a volume limit based on ADTV is feasible with respect to thinly traded securities, and whether the volume limit for these securities should be changed. The SEC also asks whether 25 percent is a reasonable limit, and whether the “one block per week” exception, or the definition of “block” purchase should be modified.
A. The “Merger Exclusion”
The Proposal also would extend the time in which the safe harbor is unavailable in connection with acquisitions by Special Purpose Acquisition Companies (“SPACs”).8 Currently, the definition of “Rule 10b-18 purchase” excludes bids and purchases made during certain corporate events such as mergers, because there may be increased incentive for an issuer to move its stock price to facilitate the transaction. Rule 10b-18(a)(13)(iv) (the “merger exclusion”) currently excludes from the definition of “Rule 10b-18 purchase” those purchases effected between the time of the public announcement of a merger, acquisition, or similar transaction involving recapitalization, and the earlier of completion of the transaction or of the target shareholder vote.
According to the SEC, SPAC acquisitions can present unique conflicts of interest and significant financial incentives for SPAC management. A SPAC acquisition generally must be completed within 18 to 24 months, placing significant time pressure on management. If management believes that SPAC holders will vote against an acquisition, they may attempt to repurchase a substantial quantity of the SPAC’s common stock in order to reduce that possibility. Such purchases also can raise the market price of the SPAC shares, and can cause other investors to buy the SPAC shares when they otherwise might not. The SEC is thus proposing to add a provision to the rule that would increase the time in which the safe harbor is unavailable in connection with an acquisition by a SPAC, by providing that the “merger exclusion” applies during the period between the public announcement of a merger, acquisition, or similar transaction and the earlier of such transaction or completion of the vote by both the target shareholders and the SPAC shareholders.
B. Accelerated Share Repurchase Plans and Forward Contracts
The Proposing Release notes that the safe harbor is not available for issuers and broker-dealers engaging in “accelerated share repurchase plans” or using forward contracts to repurchase issuer stock. The SEC asks for comments on what (if any) manipulative concerns are raised by such methods of repurchasing securities (e.g., using derivatives or share accumulation programs), and what limitations should apply to such repurchases to address those concerns.
C. Other Issues for Comment
In addition to the foregoing, the SEC asks a number of questions regarding application of the Rule to other situations, including:
- Whether the safe harbor should continue to apply to less liquid, less transparent securities, such as OTC Bulletin Board and Pink Sheet securities, and, if so, whether they should be subject to more restrictive limitations.
- Whether the safe harbor should be available during periods when an issuer’s insiders are selling their own shares of the stock and, if not, what limitations would be appropriate.
- Whether the Rule should require current financial disclosures as a prerequisite to the safe harbor’s protection, and any other possible prerequisites.
- Whether the Rule should contain specific disclosure requirements and, if so, the types of information that would be useful, whether disclosure should be required daily or more frequently (e.g., “real time” disclosure), and how such disclosure should be made (e.g., daily press releases, notices on issuer websites, special modifiers on trade reports).
- Whether the safe harbor should be available for securities other than common equity, and how the Rule’s conditions should apply to such securities.
- Whether the safe harbor should apply to issuer repurchases of common stock effected outside of the United States, and whether different conditions should apply.
Finally, the SEC requests comments on advantages and disadvantages of the Proposal, views and data as to its associated costs and benefits, and comments regarding any other matters that may have an effect on the Proposal. Comments should be submitted on or before March 1, 2010.