[Federal Register: August 10, 2007 (Volume 72, Number 154)]
[Rules and Regulations]
[Page 45093-45107]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10au07-12]
[[Page 45093]]
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Part II
Securities and Exchange Commission
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17 CFR Part 242
Short Selling in Connection With a Public Offering; Final Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-56206; File No. S7-20-06]
RIN 3235-AJ75
Short Selling in Connection With a Public Offering
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting amendments to Regulation M to further safeguard the integrity
of the capital raising process and protect issuers from manipulative
activity that can reduce issuer's offering proceeds and dilute security
holder value. The amendments eliminate the covering element of the
former rule.
DATES: Effective Date: October 9, 2007.
FOR FURTHER INFORMATION CONTACT: James Brigagliano, Associate Director,
Josephine Tao, Assistant Director, Elizabeth Sandoe, Branch Chief,
Victoria Crane, Branch Chief, and Joan Collopy, Special Counsel, at
(202) 551-5720, Office of Trading Practices and Processing, in the
Division of Market Regulation, Securities and Exchange Commission, 100
F Street, NE., Washington, DC 20549-6628.
SUPPLEMENTARY INFORMATION: We are amending Rule 105 of Regulation M [17
CFR 242.105].
I. Background
Pricing integrity is essential to the capital raising process. A
fundamental goal of Regulation M, Anti-Manipulation Rules Concerning
Securities Offerings, is protecting the independent pricing mechanism
of the securities market so that offering prices result from the
natural forces of supply and demand unencumbered by artificial
forces.\1\ Rule 105 of Regulation M governs short selling in connection
with public offerings and concerns short sales that are effected prior
to pricing an offering. The rule is particularly concerned with short
selling that can artificially depress market prices which can lead to
lower than anticipated offering prices, thus causing an issuer's
offering proceeds to be reduced.\2\ The rule is intended to foster
secondary and follow-on offering prices that are determined by
independent market dynamics and not by potentially manipulative
activity. Rule 105 is prophylactic. Thus, its provisions apply
irrespective of a short seller's intent.\3\
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\1\ See Securities Exchange Act Release No. 54888 (Dec. 6,
2006), 71 FR 75002 (Dec. 13, 2006). (``Proposing Release''). See
also Securities Exchange Act Release No. 38067 (Dec. 20, 1996), 62
FR 520 (Jan. 3, 1997) (``Regulation M Adopting Release'').
\2\ See Proposing Release, 71 FR at 75002.
\3\ See id. at 75003.
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Former Rule 105 (``former rule'') prohibited covering short sales
effected during a defined restricted period with securities purchased
in an offering (``offered securities'').\4\ ``Covering'' was the
prohibited activity. Specifically, the former rule made it unlawful for
any person to cover a short sale with offered securities purchased from
an underwriter or broker or dealer participating in the offering, if
such short sale occurred during the shorter of (1) the period beginning
five business days before the pricing of the offered securities and
ending with such pricing or (2) the period beginning with the initial
filing of such registration statement or notification on Form 1-A and
ending with pricing.\5\
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\4\ Former Rule 105(a) stated, ``[i]n connection with an
offering of securities for cash pursuant to a registration statement
or a notification on Form 1-A (Sec. 239.90 of this chapter) filed
under the Securities Act, it shall be unlawful for any person to
cover a short sale with offered securities purchased from an
underwriter or broker or dealer participating in the offering if
such short sale occurred * * *'' during the applicable Rule 105
restricted period.
\5\ See former Rule 105(a).
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In recent years, the Commission has become aware of non-compliance
with Rule 105 and, in some cases, strategies used to disguise Rule 105
violations.\6\ In particular, the Commission has become aware of
attempts to obfuscate the prohibited covering.\7\ Due to continued
violations of the rule, including a proliferation of trading strategies
and structures attempting to accomplish the economic equivalent of the
activity that the rule seeks to prevent, the Commission published
proposed amendments to Rule 105 for notice and comment.\8\
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\6\ See Proposing Release, 71 FR at 75002.
\7\ See id. at 75004.
\8\ See id. at 75002.
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The Commission proposed to eliminate the covering requirement in
order to end the progression of trading strategies designed to hide
activity that violated the rule. In particular, the Commission proposed
to make it unlawful for a person to effect a short sale during the Rule
105 restricted period and then purchase, including enter into a
contract of sale for, such security in the offering.\9\ In effect, the
proposal imposed an absolute prohibition against purchasing offered
securities in firm commitment offerings by any person that effected a
restricted period short sale(s).
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\9\ See id.
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We received 13 comment letters in response to the Proposing Release
from one self-regulatory agency, one issuer, one academic, one
investment company, four associations, and five law firms.\10\ Some
commenters supported the proposal, others opposed it, and some
commenters suggested modifications or alternative approaches. We have
carefully considered each of the comments. While the comment letters
are publicly available to be read in their entirety, we highlight many
of the issues, concerns, and suggestions raised in the letters below.
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\10\ The comment letters are available on the Commission's
Internet Web site at http://www.sec.gov/comments/s7-20-06/s72006.shtml.
Comment letters were received from (1) Millenium
Partners, L.P. dated March 19, 2007 (Millenium letter), (2) Fairfax
Financial Holdings Limited dated March 9, 2007 (Fairfax letter), (3)
Sullivan & Cromwell LLP dated Feb. 28, 2007 (Sullivan letter), (4)
NYSE Regulation, Inc. dated Feb. 27, 2007 (NYSE letter), (5) Cleary
Gottlieb Steen Hamilton LLP dated Feb. 16, 2007 (Cleary letter), (6)
James J. Angel, PhD., CFA dated Feb. 14, 2007 (Angel letter), (7)
Schiff Hardin LLP dated Feb. 14, 2007 (Schiff letter), (8)
Securities Industry and Financial Markets Association dated Feb. 13,
2007 (SIFMA letter), (9) Davis Polk & Wardwell dated Feb. 13, 2007
(Davis letter), (10) Managed Funds Association dated Feb. 12, 2007
(MFA letter), (11) Investment Company Institute dated Feb. 12, 2007
(ICI letter), (12) Morgan, Lewis Bockius LLP dated Feb. 12, 2007
(Morgan letter), and (13) International Association of Small Broker-
Dealers and Advisers dated Dec. 14, 2006 (IASBDA).
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Some commenters were supportive of the proposal and its goals.
Comment letters from an issuer and a self-regulatory organization
supported the specific proposal to eliminate the rule's covering
component and instead prohibit purchasing in the offering.\11\ One
commenter stated that, ``[t]he proposed amendments to Rule 105
meaningfully address the proliferation of trading strategies and
structures, which are designed to disguise prohibited covering
activity, by prohibiting any purchase of offered shares by someone who
sold short during the restricted period. By eliminating the covering
component and expanding the prohibition to all purchases of offered
securities, the proposed amendments will efficiently prevent persons
from engaging in strategies to avoid the appearance that offering
shares are used to cover Rule 105 restricted period short sales.'' \12\
In addition, an issuer stated the proposal would ``prevent manipulative
activity by those short sellers who inappropriately reap economic gains
to the detriment of issuers and selling shareholders who receive
reduced
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public offering proceeds.'' \13\ Commenters, including commenters that
disagreed with aspects of the proposal, supported the goals of
protecting independent pricing, bolstering investor confidence in the
capital raising process and curbing non-compliance with former Rule
105.\14\
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\11\ See NYSE and Fairfax letters.
\12\ NYSE letter.
\13\ Fairfax letter.
\14\ See, e.g., NYSE letter stating that the proposal will
``bolster investors confidence'' and ``will protect independent
pricing mechanisms and price integrity and advance the intent of
Regulation M, which is to prevent market manipulation and facilitate
offering prices based on the natural forces of supply and demand,
unencumbered by artificial influence.'' The NYSE letter further
states that it ``applauds the efforts of the Commission in proposing
amendments to Rule 105 which will promote market integrity by
precluding persons from engaging in manipulative conduct around the
pricing of an offering so that markets can be fairly determined by
supply and demand without the influence of artificial forces.'' See
also, Fairfax letter stating ``Fairfax strongly supports the
Commission's continued efforts to protect the integrity of the
securities markets' independent mechanism for pricing publicly
offered securities.'' See, e.g., ICI letter stating that ``the
Institute supports the goals of the proposal. * * *'' See also, the
Millennium letter stating ``Millennium fully agrees with the
Commission's stated goals of reducing the risk of manipulation in
connection with the pricing of offerings and eliminating 'sham' type
arrangements designed to avoid compliance with existing Rule 105.''
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Other commenters voiced opposition to the proposed amendments.\15\
One commenter stated that the proposal would: (i) Force investors to
make an investment decision at an earlier point in time before an
offering price is determined; (ii) allow issuers and underwriters to
price offerings without any market counterbalance; and (iii) harm
issuers by reducing the number of buyers for certain offerings.\16\
This commenter stated, in relevant part, ``I believe that the proposed
amendments to Rule 105 would have a deleterious effect on the market
for secondary offerings by removing from the price discovery process
those investors that pay careful attention to issuers and that the
result will be over-optimistic pricing that does not reflect the true
value of an issuer's securities. Further, I believe the proposal will
harm issuers as they will face greater costs in carrying out their
secondary offerings.'' \17\ Another commenter stated its belief that
the rule as proposed may not achieve, and in fact may be contrary to,
the Commission's investor and market protection goals.\18\
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\15\ See, e.g., Morgan letter.
\16\ See id.
\17\ See id.
\18\ See MFA letter.
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In addition to statements of support or opposition to the proposed
amendments, commenters also expressed concerns about the universe of
potential investors, price discovery, and investment company and
investment adviser violations. With respect to the investor pool,
commenters believed that the proposal could reduce the number of
investors for secondary offerings. One concern was that investors would
be forced out of secondary offerings if they effected certain trading
strategies that involved short sales during the restricted period.\19\
One commenter stated that short sales are ``effected as part of, among
other things, initial and dynamic hedging strategies, long/short
strategies, convertible arbitrage, bona-fide market making or customer
facilitation activities.'' \20\ Some commenters noted that preventing
persons that effect these strategies during a restricted period from
purchasing in an offering minimizes the pool of potential investors and
can have a negative effect on price discovery.\21\ A second concern
raised by some commenters was that investors who had no knowledge of an
offering at the time of a short sale would be prohibited from
purchasing in the offering.\22\ Commenters generally asserted that
short sales effected without knowledge of a secondary offering or
takedown, such as an ``overnight deal,'' would not be manipulative, yet
an investor would be prohibited from participating in the offering
under the proposed amendments.\23\
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\19\ See SIFMA, Sullivan, MFA, Cleary letters.
\20\ Cleary letter.
\21\ See, e.g., Davis letter stating that ``[t]rading techniques
have gotten more sophisticated and there are numerous strategies
that involve short sales * * * Often times these strategies are
employed by investors that are interested in a particular issuer and
accordingly would otherwise be likely potential purchasers in an
offering. By excluding potential investors * * * the proposed rule
would interfere with price discovery and potentially adversely
impact the pricing of the offering.'' See also, SIFMA letter stating
``[m]oreover, by effectively precluding a certain group of investors
from receiving an allocation, the proposed changes could negatively
affect pricing efficiency and could impact underwriters' decisions
on whether to commit to some offerings.''
\22\ See, e.g., MFA and Davis letters.
\23\ See, e.g., Millenium letter. See also Sullivan letter
(noting that shelf offerings also would be particularly affected by
the proposed amendments since shelf offerings are essentially
``overnight'' deals).
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Commenters were also concerned about the impact of the proposed
amendments on investment companies and investment advisers.\24\
Generally, commenters discussed two possible scenarios. First, there
would be a violation of the proposed rule if ``one fund within a fund
complex (or a series of a fund) effects a short sale during the five
day period and another fund in the same complex (or another series of a
fund) purchases the security in the offering. * * *'' \25\ Second,
commenters were also concerned about proposed rule violations ``if a
subadviser to a fund enters into a short sale in a security during the
five-day period prior to an offering, and a separate subadviser to the
same fund purchases the security in the offering. * * *'' \26\
Similarly, in response to a question in the release, commenters
suggested incorporating the aggregation unit relief concept of
Regulation SHO to Rule 105 for broker-dealers.\27\
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\24\ See Schiff letter stating that the proposal ``will have a
disparate negative and unfair effect on funds advised by registered
investment advisers that utilize multiple investment strategies or
employ multiple sub-advisers.'' See also, ICI letter suggesting that
the ``Commission clarify that each individual fund within a fund
complex (and each series of a fund), and each subadvised portion of
a particular fund, is a separate `person' for purposes of Rule 105''
or extend the aggregation unit concept set forth in Rule 200(f) of
Regulation SHO to funds.
\25\ ICI letter.
\26\ ICI letter.
\27\ See MFA, Schiff, and SIFMA letters supporting the expansion
of Regulation SHO's aggregation unit concept to registered and
unregistered entities. See also discussion regarding aggregation
units in Section II below.
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Some commenters advocated modifications to the proposed amendments
such as confining the rule's application to equity offerings and
incorporating the concept of a ``subject'' security from Regulation M
so that convertible offerings would not be impacted by the
amendments.\28\ Commenters also suggested amending the restricted
period to incorporate the concept of public announcement of an
offering.\29\ Another suggestion was to create an exception for certain
trading strategies.\30\ Another proposed
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modification was an exception based on the Rule 101 exception for
actively traded securities.\31\ Many commenters supported an exception
raised by a question in the Commission's Proposing Release to allow
restricted period short sellers to participate in an offering if they
covered such short sale(s) with a bona fide purchase prior to the
offering.\32\ However, some commenters were opposed to creating
exceptions that would undercut the rule's prophylactic nature.\33\
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\28\ See, e.g., SIFMA letter.
\29\ See, e.g., Davis letter recommending ``that the restricted
period not commence until the later of public announcement of the
offering or five business days before pricing.'' See also, SIFMA
letter suggesting that the restricted period ``not begin earlier
than the point of public announcement of the offering.'' See also,
Fairfax letter stating that ``[f]airfax recommends that, instead of
the current pre-set five day restricted period, the restricted
period should be the lesser of ten days and the period between
public announcement and pricing.''
\30\ See, e.g., MFA suggesting exceptions for bona fide
arbitrage and bona fide hedging. See also, SIFMA letter suggesting
exceptions for ``(i) convertible arbitrage; (ii) merger arbitrage;
(iii) volatility trading; (iv) long/short strategies; (v) other
hedging strategies; and (vi) bona-fide market making and customer
facilitation activities.'' See also, Cleary letter suggesting an
exception for among other things, ``bona fide hedging activities
conducted in accordance with pre-established trading strategies.''
However, one issuer was opposed to such an exception stating
that, ``[h]edging strategies, including hedging by option market
markers, should not be permitted in an issuer's securities during
the restricted period if the hedging involves receiving securities
purchased from the issuer in its public offering. Fairfax
respectfully submits that if the hedging is bona fide then any short
covering can be done using open market purchases. There is no
hedging justification that warrants encumbering issuers' capital
realization or that sufficiently outweighs the issuer's need for
market prices and offering prices that are unencumbered by
artificial and manipulative forces.'' Fairfax letter.
\31\ See, e.g., Cleary letter, suggesting an exception for
securities that are actively-traded within the meaning of Rule
101(c)(1) of Regulation M.
\32\ See Morgan, Sullivan, Davis, SIFMA and MFA letters
suggesting that an investor that sells short during the restricted
period should be able to cover such short sales prior to the
offering and participate in the offering. Other commenters were
opposed to such an exception. See, e.g., Fairfax letter stating
that, ``covering restricted period short sales in advance of pricing
would not necessarily cure any manipulative impact of the short
sales if the covering purchases have no mitigating effect on an
underwriter's decision to lower an offering's price (e.g., if the
purchase is made immediately prior to pricing such that there is no
opportunity for market reaction to the purchase in order to
dissipate any downward impact from the short sale).''
\33\ See, e.g., NYSE letter.
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Furthermore, in response to questions raised in the Proposing
Release, some commenters felt that Rule 105 should not address
derivatives,\34\ PIPE transactions,\35\ long sales,\36\ convertible
offerings,\37\ or best efforts offerings.\38\ Many commenters also were
opposed to the question in the Proposing Release as to whether we
should require underwriters to obtain certifications from investors
stating that they had not sold short during the restricted period.\39\
Other commenters sought additional interpretive guidance with respect
to former Rule 105 instead of amending the rule.\40\
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\34\ See, e.g., MFA letter.
\35\ See, e.g., SIFMA and MFA letters.
\36\ See, e.g., SIFMA and Morgan letters.
\37\ See, e.g., SIFMA letter.
\38\ See, e.g., SIFMA letter, noting that exchange-traded funds
(ETFs) are non-firm commitment offerings that ``do not involve the
type of discount which provides a motivation to `capture the
discount by aggressively short selling just prior to pricing,' and,
as a result, do not raise the policy concern that the proposed rule
changes are intended to address.'' See also Morgan and Cleary
letters.
\39\ See, e.g., SIFMA letter. However, one commenter was not
opposed to that concept. See Millennium letter.
\40\ See, e.g., Morgan letter suggesting that ``a far better
approach would be for the Commission to provide additional guidance
to the investing community regarding the specific means that it
believes would result in compliance with existing Rule 105.''
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After considering the comments received and the purposes underlying
Rule 105, we are adopting the amendments with some modifications to
refine provisions and address commenters' concerns as discussed
below.\41\
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\41\ We note that certain issues discussed in the Proposing
Release and comment letters have not been incorporated into amended
Rule 105 at this time. However, the Commission intends to monitor
whether further action is warranted. For example, amended Rule 105
continues to retain the exception for best efforts offerings. If we
become aware of potentially manipulative short selling prior to the
pricing of best efforts offerings or other concerns with this
exception, the Commission may re-evaluate this exception. By way of
another example, PIPEs generally did not fit within the elements of
former Rule 105. One reason for this is that PIPEs are typically not
conducted on a firm commitment basis. PIPE offerings not conducted
on a firm commitment basis continue to be excepted from Rule 105,
however other areas of the securities laws continue to apply to PIPE
offerings. See e.g., SEC v. Hilary L. Shane, Lit. Release No. 19227
(May 18, 2007).
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II. Discussion of Amendments
The amendments are carefully and narrowly tailored to further the
anti-manipulation goals of Rule 105 by ending the progression of
strategies designed to conceal the covering of restricted period short
sales with offered securities without unduly expanding the scope of the
rule or unnecessarily restricting the pool of secondary and follow-on
offering purchasers. The amended rule seeks to achieve this goal by
eliminating the covering element of the former rule. However, in
response to comments, as adopted, amended Rule 105 refines the
amendment as proposed in several aspects, including limiting its
application to equity offerings, and adding a ``bona fide purchase
provision'' that allows a restricted period short seller to participate
in an offering. The amended rule also includes new exceptions
concerning separate accounts and investment companies. The exception
for separate accounts allows a person to purchase the offered
securities in an account where there was a short sale in another
account 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 exception for certain
investment companies allows an investment company to participate in an
offering if an affiliated investment company or any series of such
investment company sold short during the restricted period.
The proposed amendments would have imposed an outright ban on
purchasing offered securities if a person sold short during a
restricted period. The amended rule refines that approach. As proposed
and as adopted, the amendment changes the prohibited activity from
covering to purchasing the offered security, in order to put an end to
strategies that obfuscated the prohibited covering but replicated its
economic effect.\42\ However, the amended rule also includes the three
exceptions.
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\42\ Obfuscating the prohibited covering is one way that persons
have attempted to conceal Rule 105 violations. Derivatives have also
been used to conceal Rule 105 violations by attempting to disguise a
short sale as a long sale. See e.g., Commission Guidance on Rule 3b-
3 and Married Put Transactions, Securities Exchange Act Release No.
48795 (Nov. 17, 2003), 68 FR 65820 (Nov. 21, 2003) (``Married Put
Release''). The Commission will continue to scrutinize the use of
derivatives and other attempts to conceal Rule 105 violations.
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Generally, the offering prices of follow-on and secondary offerings
are priced at a discount to a stock's closing price prior to pricing.
This discount provides a motivation for a person who has a high
expectation of receiving offering shares to capture this discount by
aggressively short selling just prior to pricing and then covering the
person's short sales at the lower offering prices with securities
received through an allocation.\43\ Covering the short sale with a
``specified amount of registered offering securities at a fixed price
allows a short seller largely to avoid market risk and usually
guarantee a profit.'' \44\ Eliminating the covering component and
prohibiting a purchase in the offering in amended paragraph (a) reduces
a potential investor's incentive to aggressively sell short prior to
pricing solely due to the anticipation of this discount. Such activity
can exert downward pressure on market prices for reasons other than
price discovery that result in lowered offering prices and therefore
reduced offering proceeds to issuers and selling security holders.\45\
The prohibition on purchasing offered securities also provides a bright
line demarcation of prohibited conduct consistent with the prophylactic
nature of Regulation M.\46 \
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\43\ See 71 FR 75003.
\44\ Id.
\45\ See Fairfax letter stating that they ``experienced a
decline in the price of a security well in excess of 3% during the
period between the public announcement of an offering and the
pricing of such offering.''
\46\ The Commission cautions that any transaction or series of
transactions, whether or not subject to the provisions of amended
Rule 105, continue to be subject to the anti-fraud and anti-
manipulation provisions of the federal securities laws. Moreover, we
remind persons intending to purchase securities in any registered
secondary or follow-on offering that selling short the same
securities prior to the offering continues to be subject to the
registration requirements of Section 5 of the Securities Act of
1933. See, e.g., SEC v. Friedman, Billings, Ramsey & Co., Inc., et
al., Civil Action No. 06-CV-02160 (D.D.C.) at http://www.sec.gov/litigation/litreleases/2006/lr19950.htm and http://www.sec.gov/
.gov/
CompuDyne stock prior to the effective date of the resale
registration statement and covering those short sales with shares of
CompuDyne stock purchased from FBR's customers who obtained shares
in the PIPE offering).
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A. Bona Fide Purchase Exception
In response to commenters' concerns, the amended rule adds a
provision that allows restricted period short sellers to purchase the
offered securities if they make a bona fide purchase of the same
security prior to pricing.\47\ This provision advances the goals of
facilitating offering price integrity and protecting issuers from
potentially manipulative activity, while not unduly restricting capital
formation or short sales. The provision provides that persons can
purchase offered securities even if they sell short during the Rule 105
restricted period if they make a purchase equivalent in quantity to the
amount of the restricted period short sale(s) prior to pricing.\48\
This provides an opportunity for a trader who had no knowledge of an
offering at the time of his short sale to participate in the offering.
Thus, a person who did not intend a strategy of shorting into an
offering has an opportunity to participate in the offering, provided
the person complies with the provision. The amendments also preserve a
person's ability to change his or her mind. For example, a person may
initially decide not to participate in an offering, and in doing so,
may sell short during the Rule 105 restricted period. If that person
subsequently decides to participate in the offering after selling short
during the Rule 105 restricted period, the bona fide purchase provision
provides an opportunity to do so.
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\47\ Amended Rule 105(b)(1).
\48\ In the Proposing Release, we had solicited specific comment
as to whether the proposed rule should provide an exception to allow
persons who effect a restricted period short sale to purchase
offered securities in certain described circumstances, including any
alternatives, and also whether such an exception should include a
documentation requirement to demonstrate compliance. See 71 FR at
75006.
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In order to take advantage of this exception, the rule requires
there to be a bona fide purchase of the security that is the subject of
the offering.\49\ While the determination as to whether a purchase is a
bona fide purchase will depend on the facts and circumstances, we note
that any transaction that, while made in technical compliance with the
exception, is part of a plan or scheme to evade the Rule, for example,
a transaction that does not include the economic elements of risk
associated with a purchase for value, would not be bona fide for
purposes of amended Rule 105.\50 \
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\49\ Amended Rule 105(b)(1)(i).
\50\ See, e.g., discussion regarding sham transactions in
Securities Exchange Act Release No. 50103 (July 28, 2004), 69 FR
48008 (Aug. 6, 2004); see also Married Put Release, supra note 42.
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The purchase must be at least equivalent in quantity to the entire
amount of the Rule 105 restricted period short sale.\51\ Partial
purchases are insufficient. This condition is designed to help ensure
that the person is making a bona fide purchase rather than simply a
purchase to evade Rule 105's prohibitions. For example, the provision
is not available if during a Rule 105 restricted period a person sells
short 1,000 shares of common stock, subsequently purchases 500 shares
of common stock prior to pricing, and then purchases 500 shares of
common stock in the offering. The 500 share pre-pricing purchase is not
equivalent in quantity to the entire amount of the Rule 105 restricted
period short sale. Thus, the provision is unavailable. In that
scenario, the person violated amended Rule 105 by short selling 1,000
shares during the Rule 105 restricted period and purchasing the offered
security.
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\51\ Amended Rule 105(b)(1)(i)(A).
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The provision also requires that the person effect the bona fide
purchase during regular trading hours \52\ and that the bona fide
purchase is reported pursuant to an effective transaction reporting
plan.\53\ This is designed to ensure transparency of the activity to
the market so that the effects of the purchase can be reflected in the
security's market price. Next, the bona fide purchase must be made
after the last Rule 105 restricted period short sale and prior to
pricing.\54\ Purchases made during the Rule 105 restricted period but
before the last Rule 105 restricted period short sale do not qualify as
a bona fide purchase for purposes of this provision. Requiring the bona
fide purchase to be made after the last Rule 105 restricted period
short sale facilitates the dissipation of downward pressure exerted by
short selling and allows any downward pressure to be offset by upward
price pressure exerted by the purchase. It also helps to ensure that
the person effected a bona fide purchase for purposes of closing out a
short sale position.
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\52\ Amended Rule 105(b)(1)(i)(B).
\53\ Amended Rule 105(b)(1)(i)(C).
\54\ Amended Rule 105(a)(1)(i)(D).
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The bona fide purchase also must occur prior to pricing to allow
market reaction to the purchase before an offering is priced.\55\ In
addition, the bona fide purchase must occur no later than the business
day prior to the day of pricing.\56\ The element that the bona fide
purchase occur no later than the business day prior to the day of
pricing also allows an opportunity for market reaction prior to pricing
an offering.\57\ For example, if an offering is priced on Wednesday
after the close of regular trading hours, the bona fide purchase could
not be made during regular trading on Wednesday. Therefore, this
provision may not be available in a truly ``overnight deal'' when an
offering commences after the close of regular trading on the day of
pricing.\58\ However, this is not an impediment to participating in an
overnight deal (or shelf offering) \59\ for potential investors who did
not short sell the security that is the subject of the offering during
the Rule 105 restricted period.
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\55\ Id.
\56\ Id.
\57\ Amended Rule 105(b)(1). But see NYSE comment letters
stating that ``[s]hort sales have the effect of driving down the
price of a security even if covered in the open market.'' See
Fairfax letter stating ``[m]oreover, covering restricted period
short sales in advance of pricing would not necessarily cure any
manipulative impact of the short sales if the covering purchases
have no mitigating effect on an underwriter's decision to lower an
offering's price * * *.''
\58\ For example, if an offering is priced after the close of
regular trading on Tuesday and underwriters begin to contact
potential investors to purchase in the offering on Tuesday evening
after pricing, the bona fide purchase provision is not available to
those investors. It would not be possible for a bona fide purchase
to be effected because the last business day prior to the day of
pricing would have already occurred.
\59\ See Sullivan letter.
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Although it would not be available to some investors in this
situation, the bona fide purchase provision is available to potential
investors in many other scenarios. For example, a person could use the
bona fide purchase provision if a Rule 105 restricted period commenced
on Monday and ended with pricing on Friday and that person sold short
on Tuesday before becoming aware of the offering on Wednesday. That
person could make bona fide purchase on Thursday as the last business
day before pricing on Friday. The bona fide purchase provision would
also be available in that situation if that person continued to sell
short on Wednesday after becoming aware of the offering. The provision
would still be available to that person if the person effected
additional short sales on Thursday prior to making a bona fide purchase
on Thursday. Thus, the bonafide purchase provision is available so long
as the conditions specified in the amended rule are satisfied.
The condition that the bona fide purchase occur no later than the
business day prior to the day of pricing
[[Page 45098]]
gives the market an opportunity to consider and react to both the Rule
105 restricted period short sales and the bona fide purchase. It
provides the market with an opportunity to consider a trading day
uninfluenced by a person with a heightened incentive to manipulate.
In addition, a person relying on this provision may not effect a
Rule 105 restricted period short sale within the 30 minutes before the
close of regular trading hours on the business day prior to the day of
pricing.\60\ This condition guards against potentially manipulative
activity near the close of trading that can lower offering prices and,
thereby reduce an issuer's offering proceeds, by influencing market
price, including the following day's opening price.
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\60\ Amended Rule 105(b)(1)(ii).
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B. Separate Accounts and Investment Company Exceptions
In the proposing release, we asked whether the principles for
independent trading unit aggregation that the Commission set out in
Regulation SHO Rule 200(f) should be extended to non-broker-dealers,
such as investment companies, and asked about appropriate criteria.\61\
Under Rule 200 of Regulation SHO and its predecessors,\62\ a person has
to aggregate all of its positions to determine whether it is net long
or short. The Commission, however, permits independent trading unit
aggregation within the same broker-dealer under certain conditions.
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\61\ Rule 200 of Regulation SHO provides that, in order to
determine its net position, a broker or dealer shall aggregate all
of its positions in a security unless it qualifies for independent
trading unit aggregation, in which case each independent trading
unit shall aggregate all of its positions in a security to determine
its net position. Rule 200(f) of Regulation SHO provides that
independent trading unit aggregation is available only if: (1) The
broker or dealer has a written plan of organization that identifies
each aggregation unit, specifies its trading objective(s), and
supports its independent identity; (2) Each aggregation unit within
the firm determines, at the time of each sale, its net position for
every security that it trades; (3) All traders in an aggregation
unit pursue only the particular trading objective(s) or strategy(s)
of that aggregation unit and do not coordinate that strategy with
any other aggregation unit; and (4) Individual traders are assigned
to only one aggregation unit at any time.
\62\ See, e.g., Rule 3b-3.
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In the Adopting Release for Regulation SHO, we noted that the
conditions required for independent trading unit aggregation were
adopted to limit the potential for trading rule violations through
coordination among units and are designed to maintain the independence
of the units.\63\ We believe the principles for independent trading
unit aggregation should be used to address concerns expressed by
commenters about the proposed rule. Specifically, commenters to the
Rule 105 proposing release expressed concerns stemming from the
Commission's use of the term ``person'' in the proposal. The proposed
rule would have prohibited ``any person'' from purchasing in an
offering if they effected restricted period short sales. Although the
former rule also used the word ``person,'' commenters stated that
eliminating the covering element could, for funds with multiple
independent accounts, ``create difficulties for funds effecting
transactions in securities that are the subject of offerings.'' \64\
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\63\ Securities Exchange Act Release No. 50103 (July 28, 2004)
69 FR 48008 at 48011 (Aug. 6, 2004) (Regulation SHO Adopting
Release).
\64\ See, e.g., ICI letter. We note that we use the term
``account'' as a general term that may encompass the separate
accounts that commenters described in many different ways including
``portions of a particular fund'' (ICI letter), ``unit'' (MFA and
SIFMA letters), ``departments'' (SIFMA letter) and ``identifiable
divisions'' (SIFMA letter).
---------------------------------------------------------------------------
Commenters expressed concern that the term ``person,'' for purposes
of the proposed rule, might encompass each fund within a fund complex,
each series of a series fund, or each subadvised portion of a single
fund. Commenters stated that, as a result, the proposed rule might
prohibit one fund within a fund complex (or a series of a fund) from
purchasing offered securities if another fund in the same complex (or
another series of a fund) sold short within the Rule 105 restricted
period even where those funds (or series of a fund) were trading
independently. Commenters also stated that the proposal would trigger a
Rule 105 violation if a sub-adviser to a portion of a fund purchased
offered securities after another sub-adviser to a different portion of
the same fund sold short during the restricted period even if those
sub-advisers were not coordinating their trading. Thus, commenters
stated that we should treat funds within a fund complex, different
series of a fund, and separate subadvised portions of a fund as
independent for purposes of Rule 105. Commenters also stated Regulation
SHO's concept of independent trading unit aggregation should be
expanded to unregistered entities.\65\
---------------------------------------------------------------------------
\65\ See e.g, MFA, Schiff, SIFMA, and Millenium letters.
---------------------------------------------------------------------------
In light of our solicitation of comment on the questions whether
the principles for independent trading unit aggregation should be
extended, and under what criteria, and in response to comments
received, we have determined to apply the principles to Rule 105 for
separate accounts in circumstances where the decisions regarding
securities transactions are made separately and without coordination of
trading or cooperation.\66\ In addition, we have included an exception
to address commenters' concerns regarding funds within the same fund
complex and different series of a fund.\67\
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\66\ For example, two sub-advised portions of the same
registered investment company may be separate accounts.
\67\ Amended Rule 105(b)(3).
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1. Separate Accounts
We are adopting an exception that will permit a purchase of the
offered security in an account of a person where such person sold short
during the Rule 105 restricted period in a separate account, if
decisions regarding securities transactions for each account are made
separately and without coordination of trading or cooperation among or
between the accounts. This exception incorporates the principles of
Rule 200(f) of Regulation SHO that permit a registered broker or dealer
to treat non-coordinating units separately.
Rule 105 is directed at persons who short sell into an offering
because they have a high likelihood of receiving discounted offering
shares. These persons have a special incentive to sell short and thus
do not contribute to efficient pricing. Where an account that sells
short is not the account that purchases shares in the offering, if
decisions regarding securities transactions for each account are made
separately and without coordination of trading or cooperation among or
between the accounts even though the accounts may be affiliated or
otherwise related, the incentive that motivates the Rule 105 violation
is not present because the short seller cannot lock in a profit by
purchasing the discounted offering shares. The exception is, therefore,
narrowly tailored to address the abuses that Rule 105 is designed to
prevent without triggering inadvertent violations by accounts that do
not coordinate their trading activity.
Indicia of Separate Accounts. For purposes of this exception,
accounts are separate and operating without coordination of trading or
cooperation if:
(1) The accounts have separate and distinct investment and trading
strategies and objectives;
(2) Personnel for each account do not coordinate trading among or
between the accounts;
(3) Information barriers separate the accounts, and information
about securities positions or investment decisions is not shared
between accounts;
(4) Each account maintains a separate profit and loss statement;
[[Page 45099]]
(5) There is no allocation of securities between or among accounts;
and
(6) Personnel with oversight or managerial responsibility over
multiple accounts in a single entity or affiliated entities, and
account owners of multiple accounts, do not have authority to execute
trades in individual securities in the accounts and in fact, do not
execute trades in the accounts, and do not have the authority to pre-
approve trading decisions for the accounts and in fact, do not pre-
approve trading decisions for the accounts.
Depending on the facts and circumstances, accounts not satisfying each
of these conditions may nonetheless fall within the exception if the
accounts are separate and operating without coordination of trading or
cooperation. Policies and procedures reasonably designed to ensure that
the above safeguards are fully implemented would be indications that
accounts are separate, as would regular reviews to help ensure that
such policies and procedures are up to date and fully implemented. For
example, such reviews may include reviewing activities that are
indicative of coordination between accounts and reviewing trading
activity of a particular account that does not appear to be consistent
with the stated strategy or objectives of such account.
We believe that accounts that have separate and distinct investment
and trading strategies and personnel that are prohibited from
coordinating trading between or among accounts would be considered to
make separate decisions regarding securities transactions for purposes
of Rule 105.\68\ These two factors are similar to the requirements of
Regulation SHO Rule 200(f)(1) and (3). We believe that these factors
are important indicators that accounts are separate for purposes of the
exception. Thus, if trading is coordinated between accounts, the
accounts will not be considered separate for purposes of this
exception.
---------------------------------------------------------------------------
\68\ See, e.g., Millenium letter; Schiff letter.
---------------------------------------------------------------------------
We believe that to meet the requirements of the exception there can
be no communication of securities positions, investment decisions or
other trading matters between accounts.\69\ Information barriers,
similar to information barriers required for registered broker-dealers
under Section 15(f) of the Securities Exchange Act of 1934 (``Exchange
Act''), will also inhibit coordination and help maintain the separation
of accounts. Information leakage, which can occur for various reasons
such as close proximity of trading desks or because traders are unaware
that they should not pass information between or among accounts, can
give rise to either deliberate or inadvertent coordination of shorting
into an offering. Similarly, the sharing of personnel with decision-
making authority regarding trading activities in different accounts may
lead to information leakage, whether deliberate or inadvertent, between
or among accounts. Information barriers should include, at a minimum,
appropriate physical barriers as well as training for all personnel.
---------------------------------------------------------------------------
\69\ Commenters believed that information barriers were
important to ensure separation of accounts See, e.g., Millenium and
Sullivan letters.
---------------------------------------------------------------------------
In the case of an owner of multiple separate accounts, information
barriers may not be necessary so long as the account owner is not
influencing the trading decisions, i.e., the owner does not allocate
securities between or among accounts; has no authority to execute
trades in individual securities in the accounts; and has no authority
to pre-approve trading decisions for the accounts.
Another indicator that accounts are separate is the maintenance of
separate profit and loss statements for each account. While an entity
may also want to ensure that accounts have separate legal identities
and separate taxpayer identification numbers, we believe that
maintaining separate profit and loss statements indicates that an
account is operating separately from other accounts, and is being
treated by common management as separate.
Another factor that indicates separateness is restricting personnel
with management or oversight responsibilities over the entity from
allocating securities between or among accounts. This factor is
designed to ensure that when one account receives an offering
allocation after the other account sells short, the offering allocation
is not transferred to the account that sold short. Such a transfer
would be contrary to the exception, which is that accounts be separate
and free of coordination or cooperation among or between other
accounts.
A further factor that indicates separateness is restricting a
person with oversight or managerial responsibility over multiple
separate accounts from having authority to execute trades in individual
securities in the accounts or the authority to pre-approve trading
decisions for the accounts and such person does not execute trades for
the account and does not pre-approve trading decisions for the
accounts. This is designed to ensure non-coordination by a single
person with control over multiple accounts. Thus, such person may
neither direct an account to sell short during the restricted period,
nor direct another account to purchase securities in an offering. In
some circumstances, the manager may receive allocations and his
allocating offering shares to an account that has a restricted period
short sale would be a violation of Rule 105. If allocation of the
offered securities is effected by a formula or predetermined basis, an
account that has a restricted period short sale must not receive the
offering shares.
Examples of persons eligible for the separate account exception
include:
An individual investor who invests capital in two or more
accounts and grants full discretionary trading authority to the
respective managers of each account, if the individual investor cannot
coordinate trading between the accounts or make investment decisions
for the accounts, and the managers do not coordinate trading between
the accounts.
An adviser that provides capital to two or more advisers
or two private investment funds, if the funds are separate legal
entities, maintain different accounts and separate profit and loss
statements, and do not coordinate trading or share information or
allocate securities between the accounts.
A money manager that provides capital to two separate
advisers, if the funds managed by the advisers are separate legal
entities, competitive with one another, maintain different accounts and
separate profit and loss statements, and do not coordinate trading or
share information or allocate securities.
An adviser that operates a black box using a trading
algorithm, if the black box is separate from another black box or
another trading unit.
We note that a fund that invests in multiple funds and owns shares
of each fund rather than shares of each fund's underlying investments
will likely not need to rely on this exception when one of the multiple
funds sells short during the restricted period and another one
purchases offered securities. In such cases, the shares of each fund
are different securities from the underlying securities. For example, a
hedge fund that invests in several other, unaffiliated hedge funds and
does not coordinate the trading activity of these funds would not
violate Rule 105 if a particular hedge fund in which the fund invested
may have sold short underlying securities during a restricted period
and another hedge fund in which the fund has invested purchased
securities in a subsequent offering.
Some registered investment companies retain multiple investment
[[Page 45100]]
sub-advisers whose activities are subject to the supervision of a
single, primary investment adviser. In such instances, each sub-advised
portion of that fund or series may be able to rely on the exception in
amended Rule 105(b)(2). In particular, if a sub-adviser to a registered
fund, or a series of that fund, engages in a short sale of a security
while another sub-adviser to the same fund or series goes long in that
security through an offering enumerated in the rule, those decisions
would be viewed as being made separately and without coordination of
trading or cooperation among or between the sub-advised portions,
provided that the sub-advisers met the elements of Rule 17a-10(a)(1)-
(2) under the Investment Company Act of 1940 (``Investment Company
Act''), and provided further that the fund's, or series', primary
investment adviser does not execute trades in individual securities,
and does not pre-approve trading decisions for the sub-advised
portions.
We believe the exception provides a carefully honed response to the
comments we received on this issue. The factors regarding separateness
are provided to assist entities in determining whether they qualify for
the exception. We note that these factors are not exhaustive, and
persons otherwise may be able to rely on this exception. We understand
that there may be other types of structures and entities that have
safeguards and protections that fall within the exception. In addition,
we will consider specific requests for exemptive relief on a case-by-
case basis.
We will closely monitor whether use of the exception in any way
undermines the purposes of Rule 105, and will consider whether further
guidance or changes to the exception are appropriate. We note that an
entity that does not comply with the exception may be in violation not
only of Rule 105, but also the antifraud provisions. For instance,
evidence of coordination, cooperation, or attempts to circumvent the
rule or hide coordinated or cooperative activity could be evidence of
fraud or manipulation for purposes of Section 10(b) of the Exchange Act
and Rule 10b-5 thereunder.
2. Investment Companies
In adopting Regulation SHO, we noted that the conditions required
for independent trading unit aggregation were adopted to limit the
potential for abuse associated with coordination among units and are
designed to maintain the independence of the units.\70\ The fact that
brokers and dealers are subject to the oversight of self-regulatory
organizations and have compliance responsibilities with regard to
supervisory procedures and books and records requirements provided
additional assurances that the Commission's concerns would be
addressed.
---------------------------------------------------------------------------
\70\ Regulation SHO Adopting Release, 69 FR at 48011.
---------------------------------------------------------------------------
Similarly, provisions of the Investment Company Act generally
prohibit concerted action between funds in a complex and between
different series of the same fund. Section 17(d) of the Investment
Company Act and Rule 17d-1 thereunder prohibit an affiliated person of
a registered investment company, and the affiliates of that affiliated
person, acting as principal, from participating in any joint
enterprise, or other joint enterprise or arrangement with their
affiliated investment company. Funds in the same investment company
complex will generally be affiliates of each other.\71\ An arrangement
by which one fund sells a security short while another affiliated fund
intentionally goes long to cover that position would generally be the
type of joint arrangement that is prohibited by Section 17(d) and Rule
17d-1. As a result, Section 17(d) and Rule 17d-1 would prevent these
persons from engaging in activities that the amended rule 105 seeks to
prohibit.
---------------------------------------------------------------------------
\71\ See, e.g., Steadman Security Corp., 46 S.E.C. 896, 920 n.81
(1977) (``the investment adviser almost always controls the fund.
Only in the very rare case where the adviser's role is simply that
of advising others who may or may not elect to be guided by his
advice * * * can the adviser realistically be deemed not in
control.'').
---------------------------------------------------------------------------
Rule 105 is directed at persons who sell short into an offering
because they have a high expectation of receiving discounted offering
shares. These persons have a heightened incentive to sell short to
affect the price of the offered securities that they intended to
purchase in order to lock in a profit. However, if the account that
sells short during the restricted period is prohibited from concerted
action with the account that purchases in the offering, the ability to
lock in a profit from selling short prior to pricing and purchasing the
offered securities is not present.
Thus, in response to comments, we are including an exception in
amended Rule 105 related to registered investment companies. Under this
exception, an individual fund within a fund complex, or a series of a
fund, will not be prohibited from purchasing the offered security if
another fund within the same complex or a different series of the fund
sold short during the Rule 105 restricted period.\72\
---------------------------------------------------------------------------
\72\ Where there are multiple subadvisers to the same fund or
series, each sub-advised portion of that fund or series may be able
to rely on the exception in amended Rule 105(b)(2) for separate
accounts, for example, if each sub-adviser relies on and acts
consistently with rules or exemptions that require the
implementation of contractual provisions prohibiting consultation
between subadvisers.
---------------------------------------------------------------------------
By applying Regulation SHO's aggregation unit concept in this
manner, we believe we have addressed commenters' concerns regarding the
amended rule's scope with respect to investment companies registered
under the Investment Company Act and accomplished the goals of Rule
105, the prevention of manipulation and the facilitation of offering
prices based on the natural forces of supply and demand.
C. Additional Amendments
The amendments modify paragraph (a) of the former rule in several
other ways. First, the amendment refines the scope of the rule by
restricting its application to offerings of ``equity'' securities for
cash. The former rule was silent as to the rule's application solely to
``equity'' securities. However language in Rule 10b-21, the predecessor
to Rule 105, did limit application of the rule's prohibitions to short
sales of ``equity securities of the same class as securities offered
for cash'' and the Commission, in adopting Rule 105, did not express
its intent to alter the reach of the rule beyond equity securities.\73\
We received comment on the Proposing Release suggesting that including
debt securities in the rule is unnecessary because debt securities are
less susceptible to manipulation.\74\ According to commenters, this is
because debt securities trade more on the basis of factors such as
yield and credit rating and are priced on factors such as interest
rates, and short sales of debt securities prior to pricing of a debt
offering are not common.\75\ Although the amendments clarify the scope
of the rule to apply only to ``equity'' securities, the Commission
intends to continue to monitor whether trading patterns in debt
securities raise manipulative concerns in connection with debt
offerings. We also received comment on the Proposing Release suggesting
that the proposal be modified to include an exception for actively-
traded securities within the meaning of Rule 101(c)(1) of
[[Page 45101]]
Regulation M.\76\ However, many of the securities that were involved in
the enforcement cases brought by the Commission alleging violations of
former Rule 105 far exceeded the public float value in the Regulation M
``actively-traded'' threshold level (that is, having an average daily
trading volume value of at least $1 million and a public float value of
at least $150 million).\77\ Moreover, we believe that the bona fide
purchase provision will address commenters' concerns for additional
flexibility for actively-traded securities without having to carve out
an additional exception for such securities.
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\73\ Former Rule 10b-21.
\74\ See, e.g., SIFMA letter.
\75\ See e.g., Id. This commenter also noted that including debt
securities in the amended rule would be inconsistent with the
overall limited application of Regulation M's prohibitions to debt
securities. See id.
\76\ See, e.g., Cleary, SIFMA, MFA letters.
\77\ See e.g, SEC v. Galleon Management, L.P, Civil Action No.
1: 05CV1006 (RMU) (May 19, 2005) in which Galleon participated in an
August 2003 offering of Centene Corp. The Form 10-K for Centene
Corp., for the fiscal year ended December 31, 2003, reported a
$404,751,936 aggregate market value of the voting and non-voting
common equity held by non-affiliates which exceeds the $150 million
public float threshold in Regulation M's actively-traded securities
exception.
---------------------------------------------------------------------------
The amendments also encompass offerings made pursuant to Form 1-E,
Notification under Regulation E. Regulation E exempts from registration
under the Securities Act of 1933 (``Securities Act'') securities issued
by registered small business investment companies or by investment
companies that have elected to be regulated as business development
companies pursuant to Section 54(a) of the Investment Company Act.\78\
Regulation E was originally patterned after Regulation A under the
Securities Act.\79\
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\78\ 17 CFR 230.601-610a (2007).
\79\ See Amendments to the Offering Exemption Under Regulation E
of the Securities Act of 1933, Securities Act Release No. 6526 (Apr.
25, 1984). Although we subsequently amended Regulation A to change
its requirements, those amendments do not affect the trading
activities that are subject to Rule 105.
---------------------------------------------------------------------------
We have long recognized the danger posed by market participants
using securities obtained pursuant to an offering under Regulation A to
cover short positions.\80\ We asked the following question in the
Proposing Release: Regulation E under the Securities Act provides
certain small business investment companies and business development
companies with a registration exemption that is similar to Regulation
A. Should Rule 105 apply to offerings made pursuant to Form 1-E,
Notification under Regulation E? \81\ We received no public comment
arguing against including Regulation E in Rule 105's purview, or
articulating why offerings under Regulation E should not be subject to
Rule 105.
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\80\ See, e.g., Short Sales in Connection with a Public
Offering, Securities Exchange Act Release No. 26028 (Aug. 25, 1988)
(subjecting offerings made pursuant to an offering under Regulation
A to the provisions of Rule 10b-21(T), a predecessor rule to Rule
105).
\81\ 71 FR at 75007.
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In light of the important investor protections that Rule 105
provides, we have determined that it is prudent that offerings under
Regulation A and Regulation E should be treated identically under Rule
105. We are concerned that short selling of securities issued pursuant
to Regulation E during a Rule 105 restricted period raises the same
manipulative concerns to which Rule 105 is directed, and which are
present with offerings made pursuant to Regulation A. Subjecting
offerings made pursuant to Regulation E to the provisions of Rule 105
is designed to ensure that participants in the secondary market for the
securities of small business investment companies and business
development companies will enjoy the same protections afforded to
participants in the secondary market for the securities of similarly
placed non-investment companies. Including offerings made pursuant to
Form 1-E will place small business investment companies and business
development companies on an equal footing with small issuers that
utilize Regulation A. Consequently, we have amended Rule 105 to
encompass offerings made on Form 1-E.
We have also amended the language of Rule 105(a) to include the
term ``subject security'' and harmonize it with language used in other
Regulation M rules. The amended rule states that it is unlawful for any
person to sell short the security that is the ``subject'' of the
offering and purchase offered securities. The term ``subject'' security
is included in Regulation M Rule 100's definition of covered
security.\82\ Rule 100 defines a covered security as ``any security
that is the subject of the distribution, or any reference security.''
\83\ While amended and former Rule 105 apply to offerings of securities
rather than to distributions, the ``subject'' security language is
consistent with Regulation M and, in response to commenters concerns,
clarifies that the amended rule does not apply to reference securities.
Therefore, in an offering of securities convertible into common equity,
even though the convertible securities are themselves equity
securities,\84\ a person may still sell short the underlying common
equity and purchase the convertible security in the offering without
violating Rule 105.\85\ Convertible offerings appear to be priced on
many factors in addition to the underlying equity's price, such as
credit rating, which may make convertible offerings less susceptible to
manipulation through pre-pricing short sales. However, the Commission
will continue to monitor the convertible offering market and may re-
evaluate these offerings.
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\82\ 17 CFR 242.100.
\83\ 17 CFR 242.100.
\84\ Any security convertible into an equity security is,
likewise, an equity security. See Exchange Act Rule 3a11-1.
\85\ While, for purposes of Regulation M, the underlying common
equity is not the subject of the convertible securities
distribution, sellers should be aware that the registration
provisions of the Securities Act of 1933 may still apply to both the
convertible security and the underlying equity security at the time
of the offering.
---------------------------------------------------------------------------
In response to commenters' concerns, amended paragraph (a) retains
the language of the former rule that the purchase of the offered
security is made ``from an underwriter or broker or dealer
participating in the offering.'' Although we stated in the Proposing
Release that the language ``from an underwriter or broker or dealer
participating in the offering'' was unnecessary because Rule 105 covers
shelf offerings now, three of the commenters stated their belief that
retaining this language is necessary in order not to extend the scope
of the rule to unnecessarily preclude a broker or dealer from
participating in an offering as a distribution participant, and
purchasing the offering securities from the issuer as part of the
distribution process, in situations where a unit within the same
broker-dealer firm may have effected a Rule 105 restricted period short
sale.\86\ Thus, a broker or dealer is not precluded from participating
in an offering as a distribution participant and may purchase the
offering securities from an issuer as part of the distribution process
if a unit within the same firm effected a short sale(s) during the Rule
105 restricted period.
---------------------------------------------------------------------------
\86\ See SIFMA, Davis, MFA letters.
---------------------------------------------------------------------------
Amended paragraph (a) also retains the ``purchase'' language of the
former rule. The Proposing Release used the language ``purchase,
including enter into a contract of sale for, the security in the
offering.'' We have determined that it is not necessary to include the
additional language regarding ``enter into a contract of sale'' because
a purchase or sale under the Securities Act includes any contract of
sale.\87\ Thus, for purposes of amended Rule105, the purchase occurs at
the time the investor becomes committed by agreement or is commitment
to buy the
[[Page 45102]]
offered security, whether such agreement is oral or written.\88\
---------------------------------------------------------------------------
\87\ See, e.g., Securities Offering Reform, Release No. 33-8591,
70 FR 44722, 44765 and at note 391 (``Securities Offering Reform'').
See also MFA Letter (commenting on the ``contract of sale''
language).
\88\ See Securities Offering Reform at n.391 (referring to
Securities Act Section 2(a)(3) and noting, in relevant part, that,
``Courts have held consistently that the date of a sale is the date
of contractual commitment, not the date that a confirmation is sent
or received or payment is made. See, e.g., Radiation Dynamics, Inc.
v. Goldmuntz, 464 F.2d 876, 891 (2d Cir. 1972) (holding that a
purchase occurs at ``the time when the parties to the transaction
are committed to one another''); In re Alliance Pharmaceutical
Corp., Secs. Lit., 279 F. Supp. 2d 171, 186-187 (S.D.N.Y. 2003)
(following the holding in Radiation Dynamics with respect to the
timing of a contract of sale); Pahmer v. Greenberg, 926 F. Supp. 287
(citing Finkel v. Stratton Corp., 962 F.2d 169, 173 (2d Cir. 1992)
(``[A] sale occurs for Section 12[(a)](2) purposes when the parties
obligate themselves to perform what they have agreed to perform even
if the formal performance of their agreement is to be after a lapse
of time'')); Adams v. Cavanaugh Communities Corp., 847 F. Supp.
1390, 1402 (N.D. Ill. 1994) (noting that the Seventh Circuit has
followed the Radiation Dynamics decision).''
---------------------------------------------------------------------------
The amendments to Rule 105 are targeted and narrow, and thus do not
restrict short sales beyond what the Commission believes is necessary
to address recent non-compliance and strategies to conceal the
prohibited covering of the former rule. While some commenters suggested
shortening the rule's restricted period to incorporate the concept of
public announcement of an offering,\89\ we believe that there is a risk
that an investor could learn about a potential shelf offering before it
is publicly announced and would still be permitted to sell short even
with the knowledge of an upcoming offering.\90\ In addition, the
amendments will help promote the process of capital formation.
Moreover, in response to commenters, the absolute ban on purchasing
offered securities in the Proposing Release has been refined to address
many of the commenters' concerns, while still advancing the goals of
the Rule.
---------------------------------------------------------------------------
\89\ See, e.g., Davis, SIFMA, Fairfax letters, supra note 29.
\90\ See Sullivan letter.
---------------------------------------------------------------------------
The amended rule does not ban short sales. Traders can sell short
during a Rule 105 restricted period if they choose not to purchase
offered securities. Traders can sell short prior to the restricted
period and receive an offering allocation. Compliance with the bona
fide purchase provision also allows traders to sell short during the
Rule 105 restricted period and receive an allocation. The bona fide
purchase provision is designed to promote capital formation while the
conditions for the provision are designed to reduce artificial
influences on pricing. As such, the bona fide purchase provision
advances the Commission's investor and market protection goals. At the
same time, the provision addresses commenters' concerns regarding not
having to make investment decisions before the offering price is
determined, allowing issuers and underwriters to price offerings with
``market counterbalance,'' and not reducing the number of buyers for
certain offerings.\91\ Additionally, while several commenters suggested
that a better approach for the Commission would be to simply provide
additional interpretive guidance to the investment community as to what
constitutes ``covering'' for purposes of former Rule 105, we believe
that the amendments provide a bright line demarcation of prohibited
activity that is consistent with the prophylactic nature of Regulation
M and that will likely better deter non-compliance with Rule 105. Thus,
the amendments provide additional guidance to the investment community
in terms of compliance with Rule 105, but while still addressing
potentially manipulative activity in a manner that may more effectively
bolster issuer and investor confidence in the offering process and thus
encourage capital formation.
---------------------------------------------------------------------------
\91\ See, e.g., Morgan letter.
---------------------------------------------------------------------------
III. Derivatives
In the Proposing Release, we stated our understanding that persons
may use options or other derivatives in ways that may cause the harm
that Rule 105 is designed to prevent and requested comment on trading
strategies involving derivatives that may depress market prices and
result in lower offering prices to issuers in ways not covered by then
current Rule 105 or the proposal.\92\ The Commission requested specific
detail about particular derivatives used, transactions, and the role of
the parties involved in the transactions. Commenters did address the
issue of derivatives but only to a limited extent.\93\ For example, one
commenter requested that the Commission specifically prohibit short
sales of, and equivalent transactions in, derivative securities from
Rule 105.\94\ This commenter noted that Commission guidance about the
applicability of the general anti-manipulation rules has not been
effective in preventing short sellers intent on manipulating an
issuer's securities from using various synthetic shorts, married puts
and sham transactions to accomplish indirectly what Rule 105 prohibits
directly.\95\ Similarly, another commenter also noted that derivatives
strategies, including married puts and sham swap transactions, have
been utilized to avoid the prohibitions of Rule 105 and that new
creative strategies that involve other derivatives which fall outside
these parameters are likely in the future.\96\ One commenter stated its
belief that applying Rule 105 to transactions in derivatives ``would be
another significant departure from the Commission's philosophy
underlying Regulation M and the covering of derivatives in its
prophylactic rules.\97\ Another commenter stated its belief that
``derivatives'' is a term that is both too broad and too vague to
properly be addressed as one all encompassing entity under a rule.\98\
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\92\ Proposing Release, 71 FR at 75005.
\93\ See, e.g., Fairfax letter.
\94\ Id.
\95\ Id.
\96\ NYSE letter.
\97\ MFA letter.
\98\ Morgan letter (noting also that the Commission had
previously seen the linkages between prices in these markets and the
primary market as too attenuated to be a direct influence and too
attenuated to permit effective manipulation of the primary market
and that, because of the large number of different types of
derivatives and the attenuated price relationship among the
derivatives and the underlying stock, a blanket application to
derivatives would result in unnecessary and complicated regulation).
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In view of above-referenced comments, the Commission will continue
to monitor the use of derivative strategies that may replicate the
economic effect of the activity that Rule 105 is designed to prevent.
Among the issues we will monitor and evaluate further is whether the
link between the derivatives trading and the underlying equities is
sufficiently attenuated as not to warrant additional regulation. In
addition, we will consider the extent to which derivative strategies
are a functional substitute for the equity trading covered by the rule.
We also note that any transaction or series of transactions remain
subject to the anti-fraud and anti-manipulation provisions of the
securities laws even if they do not implicate Rule 105.
IV. Paperwork Reduction Act
There is no collection of information requirement within the
meaning of the Paperwork Reduction Act for Rule 105.
V. Cost-Benefit Analysis
We are sensitive to the costs and benefits of Rule 105 and we have
considered the costs and benefits of the adopting amendments. To assist
us in evaluating the costs and benefits, in the Proposing Release, we
encouraged commenters to discuss any costs or benefits associated with
the proposal. Commenters were requested to provide analysis and data to
support their views on the costs and benefits associated with the
proposal. Commenters were encouraged to discuss any additional
[[Page 45103]]
costs or benefits or reductions in costs in addition to those discussed
in the Proposing Release. The Commission requested comment on potential
costs for modification to any computer systems and any surveillance
mechanisms as well as any potential benefits resulting from the
proposal for issuers, investors, broker or dealers, other securities
industry professional, regulators, or other market participants. No
comment letters provided estimates of specific costs.
A. Adopted Amendments to Rule 105 of Regulation M
In general, former Rule 105 prohibited persons who sold short prior
to pricing certain offerings during a defined restricted period from
covering such short sales with offering securities. The prohibited
activity was the covering. Under the amendments, the prohibited
activity is now purchasing in the offering. As amended, Rule 105 of
Regulation M makes it unlawful in connection with an offering of equity
securities for cash pursuant to a registration statement or a
notification on Form 1-A (Sec. 239.90) or Form 1-E (Sec. 239.200)
filed under the Securities Act (``offered securities''), for any person
to sell short the security that is the subject of the offering and
purchase the offered securities from an underwriter or broker or dealer
participating in the offering if such short sale was effected during
the period that is the shorter of the period beginning five business
days before the pricing of the offered securities and ending with such
pricing or beginning with the initial filing of such registration
statement or notification on Form 1-A or Form 1-E and ending with the
pricing. The amendments provide, however, that it shall not be unlawful
for such person to purchase the offered securities if such person makes
a bona fide purchase(s) of the security that is the subject of the
offering that is at least equivalent in quantity to the entire amount
of the Rule 105 restricted period short sale(s). The purchase must be
effected during regular trading hours, reported to an effective
transaction reporting plan, and effected after the last Rule 105
restricted period short sale, prior to pricing and no later than the
business day prior to the day of pricing. In order to rely on the bona
fide purchase provision, a person may not effect a short sale, which is
reported to an effective transaction reporting plan, within the 30
minutes prior to the close of regular trading hours on the business day
prior to the day of pricing.
In addition, the amendments provide exceptions for separate
accounts and investment companies. Accordingly, the purchase of the
offered security in an account of a person shall not be prohibited
where such person sold short during the Rule 105 restricted period in a
separate account, if decisions regarding securities transactions for
each account are made separately and without coordination of trading or
cooperation among or between accounts. Further, the amendments include
an exception for investment companies registered under Section 8 of the
Investment Company Act that allow such an investment company to
participate in an offering if an affiliated investment company or any
series of such company sold short during the restricted period.
The goal of Rule 105 is to promote offering prices that are based
upon market prices determined by supply and demand rather than
artificial forces. The rule is prophylactic and prohibits the conduct
irrespective of the short seller's intent. The amended rule eliminates
the covering requirement of the former rule because there had been non-
compliance with the former rule coupled with persons effecting
strategies to hide the prohibited covering.
B. Benefits
The amendments are intended to end the proliferation of strategies
designed to hide covering restricted period short sales with offered
securities. The amendments seek to fulfill this objective by
eliminating the covering requirement. Putting an end to activity
designed to conceal covering with offered securities but replicate the
same economic outcome is expected to better deter those attempting to
place artificial downward pressure on market prices, which can lower
offering prices and thereby reduce an issuer's offering proceeds. The
amendments are expected to benefit issuers because they likely will
receive offering proceeds that are not lower than anticipated due to
short sales prior to pricing by persons who would cover such short
sales with offering securities and then attempt to conceal the
prohibited covering. Academic research shows that prices decline by 1-
3% on average during the five days before pricing for follow-on
offerings under the current restrictions.\99\ In its comment letter,
Fairfax Financial indicated that the academic literature underestimates
the effect of short selling during the Rule 105 restricted period and
provided an example of an offering with a larger price decline. No
commenters provided arguments suggesting that this price decline is due
to factors other than noncompliance with former Rule 105.
---------------------------------------------------------------------------
\99\ See, e.g., Shane A. Corwin, The Determinants of
Underpricing for Seasoned Equity Offers, 58 J. Fin 2249 (Oct. 2003).
Although the study does not purport to explain why this happened, it
is worth noting that the study found that prices did in fact decline
during the five day restricted period prior to the pricing of the
offering. Various reasons for this price decline have been posited
in the literature of which short selling is only one possible
explanation.
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The amendments will work to safeguard the integrity of the capital
raising process by promoting offering prices based on the independent
forces of supply and demand rather than artificial prices due to
potentially manipulative short sales prior to pricing. This may boost
investor confidence that investment decisions can be based on market
prices and offering prices that are unencumbered by artificial forces,
and thus may facilitate capital formation.
Prohibiting purchasing in the offering when one has sold short
during the restricted period provides a bright line demarcation of
prohibited activity consistent with the prophylactic nature of
Regulation M. The amended rule likely will better deter non-compliance
with Rule 105 because it may be more difficult to conceal an offering
purchase than to conceal covering. The amendments also benefit traders
who want to comply with Regulation M by providing a bright line
delineation of unlawful conduct. This bright line demarcation of
prohibited conduct is also a benefit to regulators surveilling for and
investigating potential Rule 105 violations.
The amendments clarify the pool of securities offerings to which
Rule 105 applies. Application of the rule is limited to offerings of
``equity'' securities. This precise language benefits persons
determining whether or not the rule is applicable in a particular
situation. The amended rule also harmonizes its language with other
rules of Regulation M by using the term ``subject'' security. The
amendments also benefit traders by making it clear that the rule does
not apply to reference securities so that, in a convertible offering, a
trader can sell short the underlying common equity and purchase the
convertible security in the offering without violating Rule 105.
The new provisions concerning bona fide purchases, separate
accounts, and investment companies benefit issuers because they
narrowly tailor the rule to address a specific abuse in a manner
consistent with the goals of Rule 105 without unnecessarily shrinking
the potential universe of offering investors. The bona fide purchase
provision also benefits issuers because it requires that the bona fide
purchase must occur no
[[Page 45104]]
later than the business day prior to the day of pricing. This benefits
issuers because it provides an opportunity for market reaction to the
purchase prior to pricing the offering.
The bona fide purchase provision also benefits short sellers
because they are able to effect certain short sales without being
precluded from making an offering purchase where we believe the price
impact of the purchase offsets the price impact of the short sales. The
separate account exception benefits short sellers who will not have to
restrict their short sales because of the possibility of a separate but
related account purchasing offered securities. Similarly, the
investment company exception benefits investment companies who sell
short because they will not have to restrict their short sales do to
the possibility of an affiliated investment company or any series of
such company purchasing offered securities. The separate account and
investment company provisions also benefit potential investors who may
want to purchase offered securities. These potential investors will not
be precluded from doing so because of restricted period short sales in
a separate account or affiliated investment company.
The amendments do not ban short sales. Rather, the amendments
maintain much of the prior rule's flexibility for effecting short sales
such as allowing traders to sell short prior to the restricted period
and receive an allocation, and to sell short during the restricted
period if they do not participate in an offering. Persons can also sell
short during the restricted period and participate in the offering if
they make a bona fide purchase. The amendments benefit the securities
market generally because they allow for short sales that may contribute
to pricing efficiency and price discovery.
The amendments also benefit issuers by expanding the rule's scope
to cover offerings made pursuant to Form 1-E. Issuers making such
offerings should be less likely to receive reduced offering proceeds
due to short sales effected immediately before pricing an offering.
Subjecting offerings made pursuant to Regulation E to the provisions of
Rule 105 will help to ensure that participants in the secondary market
for the securities of small business investment companies and business
development companies will enjoy the same protections afforded to
participants in the secondary market for the securities of similarly
placed non-investment companies. Similarly, including offerings made
pursuant to Form 1-E will place small business investment companies and
business development companies on an equal footing with small issuers
that utilize Regulation A.
By putting an end to activity designed to conceal covering with
offered securities but in a manner designed to replicate the same
economic outcome, the amendments are expected to lead to a reduction in
short sales in violation of Rule 105 that place artificial downward
pressure on market prices, which can lower offering prices and thereby
reduce an issuer's offering proceeds. Therefore, the amendments will
likely strengthen the ability of underwriters to set offering prices
based on independent supply and demand without being encumbered by
artificial activity in the market.
C. Costs
We recognize that the amendments to Rule 105 may result in some
costs to certain market participants. Under the former rule, persons
that effected restricted period short sales were prohibited from
covering such short sales with offering securities. Thus, persons were
required to have systems and surveillance mechanisms for information
gathering, management and recordkeeping systems or procedures in order
to comply with the former rule. For that reason, persons are not
expected to incur costs for having to develop new surveillance
mechanisms. Any existing mechanisms may need to be modified but we do
not anticipate that any costs associated with such modification will be
significant. We note, however, that one commenter stated that in order
to comply with the proposed amendments, a large trading organization
would need to implement significant changes to its trading
infrastructure to identify and track offerings subject to Rule 105.
However, while there are some differences in what persons will have to
track under the amended Rule, including potential added costs
associated with the bona fide purchase provision, persons needed to
identify and track offerings subject to the former rule, and thus, such
costs were likely already incurred when the rule was first adopted and,
therefore, any additional costs are likely to be minimal.
The adopting amendments provide that a person who sells short
during the restricted period cannot purchase in the offering. We
believe that this bright line demarcation of prohibited conduct may
perhaps even be easier to surveil and comply with, and which may lead
to reduced costs. Further, we believe that this bright line demarcation
of prohibited conduct may also lead to a reduction in costs given the
anticipated reduction in schemes that may currently be in place to
conceal covering.
We anticipate that some entities may incur costs associated with
educating traders regarding the adopted amendments and updating
compliance manuals. We do not anticipate that such costs will be
significant.
We do not anticipate that registered investment companies will
incur significant costs associated with the amendments. Many registered
investment companies do not effect short sale strategies. In addition,
the separate account exception may used by sub-advisers to the same
investment company. If the sub-advisers' accounts are separate, one
sub-adviser can purchase the offered securities if another sub-adviser
sold short during the Rule 105 restricted period. Further, the
investment company exception can be used by an individual fund within
the same complex or a series of a fund so that one fund or series can
purchase an offered security if another fund within the same complex or
a different series of the fund sold short during the Rule 105
restricted period. Accordingly, sub-advisers and investment companies
relying on these exceptions will not incur costs from altering their
trading.
There may be some costs to short sellers relying on the bona fide
purchase provision as they will need to make a market purchase in order
to participate in the offering. Moreover, under the amendments,
restricted period short sellers relying on the bona fide purchase
provision must make a purchase prior to pricing, but the purchase must
occur no later than the business day prior to the day of pricing. In
rare circumstances, there also may be costs to a person who sells short
near the 30 minutes prior to close of regular trading hours on the
business day prior to the day of pricing and is then approached to
participate in an offering. That person may incur some costs in making
the market purchase in order to participate in the offering as well as
some costs in determining the exact time of the short sale. We expect
any such cost will be minimal.
We anticipate that many persons will be able to rely on the
separate account exception based on their current structures. For
example, the exception would be available to an individual investor who
invests capital in two or more accounts, grants full discretionary
trading to the respective managers of each account, does not coordinate
trading between the accounts or make investment decisions for the
accounts and has managers that do not coordinate trading. We expect
that many individual investors with multiple accounts currently have
such a structure in place
[[Page 45105]]
and would not incur costs to comply with this exception. By way of
another example, a pension fund that provides capital to two or more
advisers may currently fall within the exception and would not incur
costs in order to comply with the separate account exception.
We do not anticipate significant costs to be incurred by persons
relying on the investment company exception. This exception allows
certain investment companies to participate in an offering if an
affiliated investment company or any series of such company sold short
during the restricted period. We expect that the investment companies
at which the exception is directed currently have structures in place
that will allow them to take advantage of the exception and thus should
not incur significant costs, if any, in relying on the exception.
There may be persons who are unable to rely on the investment
company or separate account exceptions. We note that such persons are
not required to use the exceptions and thus there is no cost associated
with the exception that a person would incur. Rather than rely on these
exceptions, such persons may instead choose not to purchase an offered
security, refrain from selling short during the restricted period if
they choose to purchase the offered security, or use the bona fide
purchase exception. A person may however, choose to voluntarily adjust
their structures so as to be able to use the investment company or
separate account exceptions and may incur costs in doing so.
There may be costs to a person that is unable to rely on the new
exceptions and chooses to seek to obtain exemptive relief from the
Commission. However, we anticipate the three new exceptions will be
used by many persons and accordingly should reduce the need for
exemptive relief. Therefore, we do not anticipate numerous requests for
exemptive relief. In addition, persons can tailor their trading so as
to not run afoul of the rule and eliminate the need for exemptive
relief.
In response to the Proposing Release, one commenter noted potential
costs associated with the possibility of the proposals impairing
trading strategies of hedge funds and other active traders, with likely
negative consequences for capital raising.\100\ Another commenter noted
that the proposals will have an adverse impact on capital raising
through secondary offerings and impose greater costs to issuers by:
forcing investors to make an investment decision at an earlier point in
time before an offering price is determined; allowing issuers and
underwriters to price offerings without market counterbalance; and
reducing the number of buyers for secondary offerings.\101\ However, we
believe that modifying the proposal to include the bona fide purchase
provision will address commenters' concerns about the potential
negative consequences or impact on capital raising, including concerns
about a decrease in the number of potential buyers in an offering and
increased costs to issuers. The provision also allows potential buyers
to decide to invest at a time much closer to the pricing of an offering
than as originally proposed.
---------------------------------------------------------------------------
\100\ See MFA letter.
\101\ See Morgan letter.
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We do not expect the amendments to result in a major increase in
costs. We expect that the amendments likely will curtail the potential
for manipulative activity that can reduce offering proceeds. The change
will provide a protective measure against abusive conduct that hampers
the capital raising process and negatively impacts issuers. We believe
that any costs associated with the amendments are justified by the
benefits derived from preventing the manipulative activity of effecting
restricted period short sales and covering with offering shares.
VI. Consideration of Burden on Competition and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act \102\ requires us, when engaging
in rulemaking and where we are required to consider or determine where
an action is necessary or appropriate in the public interest, to
consider, in addition to the protection of investors, whether the
action will promote efficiency, competition, and capital formation.
Section 23(a)(2) of the Exchange Act \103\ requires the Commission, in
adopting rules under the Exchange Act, to consider the anticompetitive
effects of any rules it adopts under the Exchange Act. Section 23(a)(2)
prohibits us from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act. In the Proposing Release, we solicited comment on
the proposal's effects on efficiency, competition, and capital
formation. Additionally, we requested comment on the potential impact
of the proposed amendments on the economy on an annual basis pursuant
to the Small Business Regulatory Enforcement Act of 1966
(``SBREFA'').\104\
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\102\ 15 U.S.C. 78c(f).
\103\ 15 U.S.C. 78w(a)(2).
\104\ Pub. L. 104-121, tit. II, 110 Stat. 857 (1996).
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In response to the Proposing Release, one commenter stated its
belief that the proposed amendments could result in unintended negative
consequences, including the creation of new hurdles that hinder the
efficiency of the capital formation process--to the ultimate detriment
of the issuers the Rule is seeking to protect.\105\ This commenter also
expressed concern about the impact of the proposed amendments in
situations where investors effect short sales during the rule's
restricted period without any knowledge that the offering is going to
occur; and that by effectively precluding a group of investors from
receiving an allocation, the proposed amendments could negatively
impact underwriters' decision on whether to commit to some
offerings.\106\ We believe that the bona fide purchase provision
addresses these concerns, in that most of these investors will not be
precluded from participating in such offerings.
---------------------------------------------------------------------------
\105\ See SIFMA letter.
\106\ See id.
---------------------------------------------------------------------------
We believe that the amendments are expected to promote capital
formation through enhanced investor confidence in the integrity of the
U.S. securities market because the amendments prohibit conduct that can
manipulate market prices and could result in lower offering
prices.\107\ Capital formation may also be facilitated because issuers
may be more likely to offer securities for sale in the U.S. securities
market because there are rules in place to deter potentially
manipulative conduct that effects offering prices. The bona fide
purchase provision will likely contribute to capital formation by
helping to ensure that the universe of potential offering investors is
not unduly limited.
---------------------------------------------------------------------------
\107\ Academic research shows that prices decline during the
five days before pricing for follow-on offerings under the current
restrictions. See supra note 99. See also Fairfax letter.
---------------------------------------------------------------------------
The amendments also promote pricing efficiency. Short sales
contributing to price discovery and efficiency can occur at any time
under Rule 105 if a person chooses not to purchase in an offering.
Persons can sell short prior to the restricted period and purchase
offering securities. In addition, the bona fide purchase provision
retains an opportunity for persons to sell short during the Rule 105
restricted period and still participate in certain offerings. The
amendments are expected to lessen the incentive to engage in trading
activity that could lead to a loss in pricing efficiency prior to when
an offering is priced because it is now more
[[Page 45106]]
difficult to obscure the prohibited activity of making an offering
purchase.
The amendments are not expected to impose a burden on competition
that is not necessary or appropriate in furtherance of the purposes of
the Exchange Act. An individual fund within a fund complex, or a series
of a fund, may rely on the investment company exception if the
conditions of the exception are met. A separately subadvised portion of
a fund may rely on the separate account exception if the conditions of
the exception are satisfied. Because of the broad diversity of other
fund structures, we will consider individual requests on a case-by-case
basis.
The Commission believes that the amendments are in the public
interest because of the strategies designed to hide the covering
prohibited by former Rule 105 and the resulting artificial downward
pressure placed on market prices, which can lower offering prices and
thereby reduce an issuer's offering proceeds.
VII. Final Regulatory Flexibility Analysis
This Final Regulatory Flexibility Analysis has been prepared in
accordance with 5 U.S.C. 603. An Initial Regulatory Flexibility
Analysis (``IRFA'') was prepared in accordance with the Regulatory
Flexibility Act in conjunction with the Proposing Release. The
Proposing Release included, and solicited comment on, the IRFA.
A. Need for the Amendments
There has been non-compliance with former Rule 105 and persons
engaging in strategies to hide that non-compliance. In particular,
persons engineered strategies to conceal the prohibited covering. We
have observed that these strategies evolved over time. The Commission
is adopting these amendments to forestall the continuation of these
obfuscating transactions and protect the integrity of the U.S. capital
raising process. We believe the amendments are necessary to cut-off the
likely future development of more complex attempts to disguise
violations of the Rule.
B. Objectives of the Amendments
The amendments are designed to facilitate offering prices
determined by independent market forces. The amendments enhance market
integrity by prohibiting conduct that can be manipulative around the
time an offering is priced so that market prices can be fairly
determined by an independent market. The amendments are designed to
promote offering prices that are determined by the natural forces of
supply and demand. We believe the amendments safeguard the integrity of
the capital raising process and protect issuers from potentially
manipulative activity that can reduce offering proceeds. The amendments
are expected to promote investor confidence in the market which should
foster capital formation.
C. Significant Issues Raised by Public Comments
The IRFA appeared in the Proposing Release.\108\ We requested
comment on the IRFA on ``(1) the number of persons that are subject to
Rule 105 and the number of such persons that are small entities; (2)
the nature of any impact the proposed amendments would have on small
entities and empirical data supporting the extent of the impact * * *
and (3) how to quantify the number of small entities that would be
affected by and/or how to quantify the impact of the proposed
amendments.'' \109\ We received one comment letter that discussed the
IRFA.\110\
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\108\ See Proposing Release Section X, 71 FR at 75009.
\109\ Proposing Release, 71 FR at 75010.
\110\ See letter from Cleary (disagreeing with the statement
that there are no duplicative rules). However, we note that the
amendments do not replace, but are designed to work in conjunction
with other provisions under the federal securities laws, such as
Exchange Act Section 10(b) and Rule 10b-5 and Securities Act Section
5.
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D. Small Entities Subject to the Rule
The amendments apply to persons that effect short sales during the
restricted period. For purposes of amended Rule 105, the term
``person'' is unchanged from the former rule. The persons covered by
the amendments include small entities. Generally, these entities were
already subject to former Rule 105 and were likely to have been
monitoring restricted period short sales. For that reason, we do not
anticipate that there will be any significant additional costs
associated with compliance with the amendments for these businesses.
Although it is impossible to quantify every type of small entity that
may sell short during a Rule 105 restricted period, paragraph (c)(1) of
Rule 0-10 \111\ states that the term ``small business'' or ``small
organization'' when referring to a broker-dealer means a broker or
dealer that had total capital (net worth plus subordinated liabilities)
of less than $500,000 on the date in the prior fiscal year as of which
its audited financial statements were prepared pursuant to Sec.
240.17a-5(d); and is not affiliated with any person (other than a
natural person) that is not a small business or small organization. As
of the start of 2006, the Commission estimates that there were
approximately 911 broker dealers that qualified as small entities as
defined above.\112\
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\111\ 17 CFR 240.0-10(c)(1).
\112\ These numbers are based on the Office of Economic
Analysis' review of 2006 FOCUS Report filings reflecting registered
broker dealers. The number does not include broker-dealers that are
delinquent on FOCUS Report filings.
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Any business, however, regardless of industry, will be subject to
Rule 105 if they sell short during the applicable restricted period.
The Commission believes that, except for the broker-dealers discussed
above, especially in the absence of commenters addressing the issue, an
estimate of the number of small entities that fall under the amendments
is not feasible.
As with the former rule, the amended rule does not distinguish
offerings by whether an issuer is small or large. Its provisions apply
equally to any offering that falls within the rule's conditions
regardless of the size of the issuer.
E. Projected Reporting, Recordkeeping and Other Compliance Requirements
The amendments may impose limited new compliance requirements on
any affected party, including broker-dealers that are small entities.
Under the amendments, persons covered by the rule who sell short during
the restricted period cannot purchase securities in the offering. While
compliance is required to ensure the prohibition is not violated, there
are no new recordkeeping or reporting obligations.
The amendments do not modify the measurement of restricted periods
that apply. Therefore, since the former rule also addresses conduct
around short selling that occurs during a Rule 105 restricted period,
the monitoring that is required of market participants to ensure
compliance with the amended rule will not change.
We note that the compliance with the amended rule is expected to be
simpler than compliance with the former rule, which prohibited
covering. Monitoring for an offering purchase, notwithstanding any
additional monitoring that may be needed to help ensure compliance with
the bona fide purchase provision, is simpler than monitoring for
covering because it is so easily identifiable. As with the former rule,
responsibility for compliance with the amendments rests with the person
that sells short during the Rule 105 restricted period. The amendments
are focused on eliminating schemes to disguise the covering prohibited
by the
[[Page 45107]]
former rule and are not intended to change compliance responsibilities.
There are no new reporting or recordkeeping requirements in the
amended rule. The amendments do not contain recordkeeping or reporting
requirements for broker-dealers or any recordkeeping or reporting
requirements unique to small entities.
F. Agency Action To Minimize Effect on Small Entities
We have considered various alternatives to accomplish our
objectives which minimize any significant adverse impact on small
entities and other entities. While we proposed a stricter rule, we
modified the proposal to include a limited bona fide purchase provision
in response to commenters' concerns. We believe that the amendments are
narrowly tailored to address particular conduct, hiding the covering
prohibited by the former rule. The amendments apply restrictions where
they are most needed and ease the proposed amendments, in light of
comments, where the risk of potentially manipulative activity is not as
great. The amendments are not expected to adversely effect small
entities because they do not impose any new recordkeeping, or reporting
requirements.
VIII. Statutory Basis and Text of Amendments
Pursuant to sections 7, 17(a), and 19(a) of the Securities Act of
1933 [15 U.S.C. 77g, 77q(a), and 77s(a)]; sections 2, 3, 7(c)(2), 9(a),
10, 11A(c), 12, 13, 14, 15(b), 15(c), 15(g), 17(a), 17(b), 17(h),
23(a), 30A, and 36 of the Exchange Act [15 U.S.C. 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g), 78q(a),
78q(b), 78q(h), 78w(a), 78dd-1, and 78mm]; and sections 23, 30, 38 of
the Investment Company Act [15 U.S.C. 80a-23, 80a-29 and 80a-37].
List of Subjects in 17 CFR Part 242
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
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In accordance with the foregoing, Title 17, Chapter II, Part 242 of the
Code of Federal Regulations is amended as follows:
PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITIES FUTURES
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1. The authority citation for part 242 continues to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
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2. Section 242.105 is amended by:
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a. Revising paragraph (a);
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b. Redesignating paragraphs (b) and (c) as paragraphs (c) and (d); and
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c. Adding new paragraph (b).
The revision and addition reads as follows:
Sec. 242.105 Short selling in connection with a public offering.
(a) Unlawful Activity. In connection with an offering of equity
securities for cash pursuant to a registration statement or a
notification on Form 1-A (Sec. 239.90 of this chapter) or Form 1-E
(Sec. 239.200 of this chapter) filed under the Securities Act of 1933
(``offered securities''), it shall be unlawful for any person to sell
short (as defined in Sec. 242.200(a)) the security that is the subject
of the offering and purchase the offered securities from an underwriter
or broker or dealer participating in the offering if such short sale
was effected during the period (``Rule 105 restricted period'') that is
the shorter of the period:
(1) Beginning five business days before the pricing of the offered
securities and ending with such pricing; or
(2) Beginning with the initial filing of such registration
statement or notification on Form 1-A or Form 1-E and ending with the
pricing.
(b) Excepted Activity--(1) Bona Fide Purchase. It shall not be
prohibited for such person to purchase the offered securities as
provided in paragraph (a) of this section if:
(i) Such person makes a bona fide purchase(s) of the security that
is the subject of the offering that is:
(A) At least equivalent in quantity to the entire amount of the
Rule 105 restricted period short sale(s);
(B) Effected during regular trading hours;
(C) Reported to an ``effective transaction reporting plan'' (as
defined in Sec. 242.600(b)(22)); and
(D) Effected after the last Rule 105 restricted period short sale,
and no later than the business day prior to the day of pricing; and
(ii) Such person did not effect a short sale, that is reported to
an effective transaction reporting plan, within the 30 minutes prior to
the close of regular trading hours (as defined in Sec. 242.600(b)(64))
on the business day prior to the day of pricing.
(2) Separate Accounts. Paragraph (a) of this section shall not
prohibit the purchase of the offered security in an account of a person
where such person sold short during the Rule 105 restricted period in a
separate account, if decisions regarding securities transactions for
each account are made separately and without coordination of trading or
cooperation among or between the accounts.
(3) Investment Companies. Paragraph (a) of this section shall not
prohibit an investment company (as defined by Section 3 of the
Investment Company Act) that is registered under Section 8 of the
Investment Company Act, or a series of such company (investment
company) from purchasing an offered security where any of the following
sold the offered security short during the Rule 105 restricted period:
(i) An affiliated investment company, or any series of such a
company; or
(ii) A separate series of the investment company.
* * * * *
Dated: August 6, 2007.
By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. E7-15608 Filed 8-9-07; 8:45 am]
BILLING CODE 8010-01-P