Short Selling in Connection With a Public Offering, 75002-75011 [E6-21141]
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Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Part 242
[Release No. 34–54888; File No. S7–20–06]
RIN 3235–AJ75
Short Selling in Connection With a
Public Offering
Securities and Exchange
Commission.
ACTION: Proposed rule.
AGENCY:
SUMMARY: The Securities and Exchange
Commission (‘‘Commission’’) is
proposing amendments to Regulation M
concerning the anti-manipulation rules
for securities offerings that would
further safeguard the integrity of the
capital raising process and protect
issuers from manipulative activity that
can reduce issuers’ offering proceeds
and dilute security holder value. The
proposal would prevent a person from
effecting a short sale during a limited
time period, shortly before pricing, and
then purchasing, including entering into
a contract of sale for, such security in
the offering.
DATES: Comments should be received on
or before February 12, 2007
ADDRESSES: Comments may be
submitted by any of the following
methods:
Electronic Comments
• Use the Commission’s Internet
comment form (https://www.sec.gov/
rules/proposed.shtml); or
• Send an e-mail to rulecomments@sec.gov. Please include File
No. S7–20–06 on the subject line; or
• Use the Federal eRulemaking Portal
(https://www.regulations.gov). Follow the
instructions for submitting comments.
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Paper Comments
• Send paper comments in triplicate
to Nancy M. Morris, Secretary,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–1090.
All submissions should refer to File
Number S7–20–06. This file number
should be included on the subject line
if e-mail is used. To help us process and
review your comments more efficiently,
please use only one method. The
Commission will post all comments on
the Commission’s Internet Web site
(https://www.sec.gov/rules/
proposed.shtml). Comments are also
available for public inspection and
copying in the Commission’s Public
Reference Room, 100 F Street, NE.,
Washington, DC 20549. All comments
received will be posted without change;
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we do not edit personal identifying
information from submissions. You
should submit only information that
you wish to make publicly available.
FOR FURTHER INFORMATION CONTACT:
James A. Brigagliano, Acting Associate
Director, Josephine Tao, Branch Chief,
Elizabeth Sandoe, Victoria Crane, and
Marlon Quintanilla Paz, Special
Counsels, (202) 551–5720, Office of
Trading Practices and Processing,
Division of Market Regulation,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–6628.
SUPPLEMENTARY INFORMATION: The
Commission is requesting public
comment on proposed amendments to
Rule 105 of Regulation M [17 CFR
242.105].
Table Of Contents
I. Introduction
II. Background
III. Discussion of Proposed Amendments
IV. Derivatives
V. Request for Comment
VI. Paperwork Reduction Act
VII. Consideration of Proposed Amendments
to Rule 105 of Regulation M’s Costs and
Benefits
A. Benefits
B. Costs
VIII. Consideration of Burden on Competition
and Promotion of Efficiency,
Competition, and Capital Formation
IX. Consideration of Impact on the Economy
X. Initial Regulatory Flexibility Analysis
A. Reasons for the Proposed Action
B. Objectives
C. Legal Basis
D. Small Entities Subject to the Rule
E. Reporting, Recordkeeping and Other
Compliance Requirements
F. Duplicative, Overlapping or Conflicting
Federal Rules
G. Significant Alternatives
H. Solicitation of Comments
XI. Statutory Basis
I. Introduction
A fundamental goal of Regulation M,
Anti-manipulation Rules Concerning
Securities Offerings, is protecting the
independent pricing mechanism of the
securities markets so that offering prices
result from the natural forces of supply
and demand unencumbered by artificial
forces.1 Price integrity is essential in the
offering process. Regulation M is
intended to foster price integrity by
prohibiting activity that interferes with
independent market dynamics, prior to
pricing offerings, by persons with a
heightened incentive to manipulate.
Regulation M consists of a
definitional rule, Rule 100, and five
additional rules, Rules 101 through
1 Securities Exchange Act of 1934 (‘‘Exchange
Act’’) Release No. 38067 (Dec. 20, 1996), 62 FR 520
(Jan. 3, 1997) (‘‘Regulation M Adopting Release’’).
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105.2 Rule 105, Short Selling In
Connection With A Public Offering,
prohibits a person from covering a short
sale 3 with securities sold in the
offering, if such person sold short
within five days prior to pricing or the
period beginning with the filing of the
registration statement and ending with
pricing, whichever is shorter. This short
selling can artificially depress market
prices which can lead to lower than
anticipated offering prices, thus causing
an issuer’s offering proceeds to be
reduced.4
We are aware of non-compliance with
current Rule 105, and in some cases,
strategies used to disguise Rule 105
violations.5 Despite interpretive
guidance regarding the application of
Rule 105,6 we have witnessed 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.
We propose amending Rule 105 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. The
proposal, like the current rule, provides
a bright line test for Rule 105
compliance consistent with the
prophylactic nature of Regulation M. In
light of evidence of non-compliance
with the current rule, we believe the
proposal would promote investor and
issuer confidence in pricing integrity
and in the offering process, which
should facilitate capital formation. In
addition, the elimination of the current
rule’s covering component is intended
to address attempts to restructure
transactions in an effort to evade Rule
105.
The proposal is narrowly tailored to
address short sales prior to pricing that
can reduce issuers’ offering proceeds
without restricting other short sales
before the offering.7 Like the current
rule, the proposal would permit persons
that effect short sales prior to the
restricted period to purchase, including
to enter into a contract of sale for, such
security in the offering and would
2 17
CFR 242.100 through 242.105.
short sale is the sale of a security that the
seller does not own or any sale that is consummated
by the delivery of a security borrowed by, or for the
account of, the seller. See 17 CFR 242.200 (2006).
4 See Regulation M Adopting Release, 62 FR at
538.
5 See infra n.18.
6 See Exchange Act Release No. 50103 (July 28,
2004), 69 FR 48008, 48020–21 (Aug. 6, 2004)
(‘‘Regulation SHO Adopting Release’’).
7 If the registered offering is on behalf of selling
security holders, the proceeds of such selling
security holders can be similarly reduced.
3A
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Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules
permit persons to sell short during the
restricted period if they do not
purchase, including enter into a contract
of sale for, such security in the offering.
We solicit specific comment on our
approach and the specific proposals. We
encourage commenters to present data
on our proposals and any suggested
alternative approaches.
II. Background
The Commission has long been
concerned that short sales effected prior
to certain offerings that are covered with
offering securities can be manipulative
conduct harmful to the market and can
have a substantial impact on issuers or
selling security holders. Rule 10b–21,8
the predecessor to Rule 105, prohibited
covering short sales with offering
securities if the short sale took place
during the period beginning at the time
that the registration statement or Form
1–A was filed and ending at the time
that sales may be made pursuant to the
registration statement or Form 1–A.9
The Commission stated that Rule 10b–
21 would ‘‘help deter a practice that the
Commission views as manipulative and
destructive of issuers’ capital raising
activities.’’ 10
Prior to Rule 10b–21’s adoption, the
Commission noted the staff’s view about
short selling prior to an offering, stating
that ‘‘it appears that such short selling
prior to the offering date has had a
substantial adverse impact on the
market price of the securities and in
some instances has caused the offerings
to be postponed temporarily, to be
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8 Rule
10b–21 was rescinded with the adoption of
Regulation M. Regulation M Adopting Release, 62
FR at 520.
9 Exchange Act Release No. 33702 (Mar. 2, 1994),
59 FR 10984 (Mar. 9, 1994) (‘‘Rule 10b–21 Adopting
Release’’). Rule 10b–21(T) was initially adopted on
a temporary basis. Exchange Act Release No. 26028
(Aug. 31, 1988), 53 FR 33455 (Aug. 31, 1988). The
Commission proposed the rule for public comment
in 1987. Exchange Act Release No. 24485 (May 20,
1987), 52 FR 19885 (May 28, 1987) (‘‘1987
Proposing Release’’). The Commission proposed
three versions of Rule 10b–21 prior to the 1987
Proposing Release. See Exchange Act Release No.
10636 (Feb. 11, 1974), 39 FR 7806 (Feb. 28, 1974);
Exchange Act Release No. 11328 (Apr. 2, 1975), 40
FR 16090 (Apr. 9, 1975); Exchange Act Release No.
13092 (Dec. 21, 1976), 41 FR 56542 (Dec. 28, 1976).
Rule 10b–21 provided that, ‘‘It shall be unlawful
for any person who effects one or more short sales
of equity securities of the same class as securities
offered for cash pursuant to a registration statement
filed under the Securities Act of 1933 (‘Securities
Act’) or pursuant to a notification on Form 1–A
under the Securities Act (‘offered securities’), to
cover such short sale or sales with offered securities
purchased from an underwriter or broker or dealer
participating in the offering, if such short sales or
sale took place during the period beginning at the
time that the registration statement or Form 1–A is
filed and ending at the time that sales may be made
pursuant to the registration statement or Form 1–
A.’’ Former Rule 10b–21(a).
10 53 FR at 33456.
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abandoned completely, or to be made at
prices lower than originally intended—
prices which do not reflect the market
value of the securities, undistorted by
artificial factors.’’ 11
Generally, the offering prices of
follow-on and secondary offerings 12 are
priced at a discount to a stock’s closing
price (depending on the exchange, the
closing transaction price, closing bid
price, or last sale 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 price with securities received
through an allocation. 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.13 Short sales during the period
immediately preceding pricing an
offering can exert downward pressure
upon a stock’s price that can result in
lower offering prices.
Some persons may decide to sell short
prior to the pricing of an offering
because they believe the security is
overpriced. This activity provides a true
price discovery mechanism for the
market and should be encouraged.
Persons who are attempting to capture
the offer price discount are not selling
short the security because the security is
overpriced; thus, they do not contribute
to true pricing efficiency.14 Instead, by
11 Exchange Act Release No. 9824 (Oct. 25, 1972),
37 FR 22796 (Oct. 25, 1972). In addition, the
Commission noted the staff’s view that ‘‘Such
investors and broker-dealers, desiring to participate
in so-called ‘hot’ issue offerings, agree to
accommodate the underwriters and therefore
participate in the so-called ‘cold’ issue. Such
persons reportedly then attempt to protect
themselves against losses by selling the securities
short prior to the distribution, intending to cover
their position with the securities being offered.’’ 37
FR at 22796.
12 The first time an issuer conducts a public
offering of its securities, the offering is referred to
as an initial public offering (‘‘IPO’’). Subsequent
offerings by the issuer are referred to as follow-on
offerings or repeat offerings. A secondary offering
is an offering of securities held by security holders,
for which there already exist trading markets for the
same class of securities as those being offered. See
Exchange Act Release No 10636 (Feb. 11, 1974), 39
FR 7806 n.1 (Feb. 28, 1974). Of course, IPOs also
may include secondary offerings by selling security
holders.
13 Of course, there are additional risks including
execution risk, quantity risk and litigation risk that
the short seller might consider. Based on our
experience, it would appear that many investors
perceive these risks as minimal because they do not
appear to deter this shorting strategy. The shorting
strategy is detailed in a number of enforcement
cases concerning Rule 105. See infra n.18.
14 ‘‘The Commission has also cautioned that ’any
person intending to purchase securities in any
registered secondary offering should be on notice
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selling the security short with the
knowledge that they are very likely to be
able to cover their short positions with
offering shares that they are allocated,
these persons may drive down the price
despite their true belief regarding the
appropriate price for that security. The
likelihood of being allocated offering
shares provides these persons with an
advantage over other persons, which
they may exploit to the detriment of
pricing efficiency. Not only is this
conduct harmful to the market and
current security holders, but it can
reduce the proceeds the issuer or the
selling security holder receives from the
securities offering.
To facilitate true price discovery, Rule
105 governs short sales immediately
prior to pricing follow-on and secondary
offerings where the short sales are
covered with offering securities.15
Currently, Rule 105 prohibits persons
from covering a short sale with offering
securities if the short sale occurred
during a Rule 105 restricted period.
Typically, the Rule 105 restricted period
begins five business days before the
pricing of the offering and ends with
pricing.16 Rule 105 is prophylactic.
Thus, its prohibitions apply irrespective
of a short seller’s intent.17 Rule 105 does
not ban short sales because certain short
sales may be motivated by a short
seller’s evaluation of a security’s future
performance and contribute to pricing
efficiency and price discovery. The rule
does not unduly restrict short selling,
and thus does not hamper true price
discovery, because persons are not
prohibited from short selling and
persons expecting to receive allocation
that his selling short the same securities prior to the
offering may be subject to the registration
requirements of Section 5 of the Securities Act [15
U.S.C. 77e] as well as other applicable statutes and
rules.’ Exchange Act Release No. 10636 (Feb. 11,
1974). Accord, Exchange Act Release Nos. 11328 n.
1 (Apr. 2, 1975) and 9824 (Oct. 16, 1972).’’
Exchange Act Release No. 26028 (Aug. 25, 1988),
53 FR 3345, 33457 (Aug. 31, 1988).
15 17 CFR 242.105. Short selling in connection
with a public offering. (a) Unlawful Activity. In
connection with an offering of securities for cash
pursuant to a registration statement or a notification
on Form 1–A (§ 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 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 such pricing.
16 See id.
17 See Exchange Act Release No. 48795 (Nov. 17,
2003), 68 FR 65820, 65822 n.22 (Nov. 21, 2003)
(stating that Rule 105 does not require a showing
of scienter). Short sales effected during the Rule 105
restricted period can depress market prices and
reduce an issuer’s offering proceeds even if the
short seller has no manipulative intent.
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of offering shares can effect short sales
prior to the Rule 105 restricted period.
In addition, short sales can be made
during the restricted period if the seller
does not cover with shares it receives in
the offering.
There has been non-compliance with
Rule 105 and examples are detailed in
numerous recent Commission
enforcement cases.18 We have seen
patterns where persons engage in
strategies to avoid the appearance that
offering shares they were allocated are
used to cover Rule 105 restricted period
short sales. Whether trading strategies
are the product of attempts to avoid
application of the rule or attempts to
conceal Rule 105 violations, they
indicate the presence of activity that the
rule is designed to prevent.
Certain of the cases illustrate activity
meant to obfuscate the prohibited
covering. One method of obscuring a
Rule 105 violation involves postoffering sales and purchases undertaken
to give the appearance that the restricted
period short sales were covered with
shares other than the offering allocation.
For example, a person (1) effects a short
sale of 5,000 shares during a Rule 105
restricted period, (2) purchases,
including enters into a contract of sale
for, 5,000 shares of the security in the
offering, (3) following the purchase, or
entry into the contract of sale, sells
5,000 shares and (4) contemporaneously
or nearly contemporaneously purchases
5,000 shares. The Rule 105 violation
may be complete when the restricted
period short sale is covered with
offering shares at step number 2 above.
Once the restricted period short sale is
executed and the person purchases,
including enters into a contract of sale
for, the offered securities, the position is
economically flat. A contemporaneous
or nearly contemporaneous post-offering
purchase and sale does not undo the
Rule 105 violation.19 In that situation, a
person may violate Rule 105 despite his
18 See, e.g., SEC v. Solar Group S.A. and James
J. Todd, No. 06–CV–12936 (SDNY Nov. 6, 2006),
Litigation Release No. 19899 (Nov. 6, 2006); SEC v.
Graycort Financial, LLC, No. C 06–6033 (NDCA
Sept. 28, 2006), Litigation Release No. 19851 (Sept.
28, 2006); SEC v. Compania Internacional
Financiera SA and Yomi Rodrig, No. 05–CV–10634
(SDNY Dec. 20, 2005), Litigation Release No. 19501
(Dec. 20, 2005); SEC v. Galleon Management, L.P.,
Litigation Release No. 19228 (May 19, 2005); DB
Investment Managers, Inc., Exchange Act Release
No. 51707 (May 19, 2005); Oaktree Capital
Management LLC, Exchange Act Release No. 51709
(May 19, 2005); SEC v. Joseph X. Crivelli, Exchange
Act Release No. 50092 (July 27, 2004); Ascend
Capital, LLC, Exchange Act Release No. 48188 (July
17, 2003); and SEC v. Ethan H. Weitz and Robert
R. Altman, Litigation Release No. 18121 (Apr. 30,
2003).
19 The Commission issued interpretive guidance
regarding transactions that are engineered to
obfuscate a Rule 105 violation. 69 FR at 48021.
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or her claim that the market purchase
following the offering, rather than the
shares acquired in the offering, covered
the short position because there is no
legitimate economic purpose or
substance to the contemporaneous
purchase and sale, no genuine change in
beneficial ownership, and/or little or no
market risk.
Certain Commission enforcement
cases illustrate variations of this tactic.
The following examples illustrate
attempted concealments of covering
through the use of crossed limit orders
and the use of market orders. Persons
may claim that a post-allocation shares
purchase, rather than the shares from
the offering allocation, are used to cover
the restricted period short sale.
However, this post offering activity may
be an attempt to conceal the prohibited
covering after the Rule 105 violation has
occurred.
The Commission has settled
proceedings in which respondents
covered restricted period short positions
in violation of Rule 105 and placed
post-offering limit orders to sell and
purchase the offered security at the
same price and in the same quantity.20
For example, 1,000 shares of an issuer’s
common stock were sold short during
the restricted period. Next, the person
purchased, including entered into a
contract of sale for, 1,000 shares of the
security in the offering. Thereafter, buy
and sell limit orders were placed to
‘‘cross’’ 1,000 shares of the issuer within
the same account. Subsequently, the
Commission has settled cases in which
the respondents effected a post-offering
sale and purchase of securities with
market orders filled at nearly the same
price.21
Another strategy to obfuscate the
prohibited covering is a practice known
as ‘‘collapsing the box.’’ In one
Commission settled case, for example, a
person created ‘‘boxed’’ positions by
maintaining a short position established
during the restricted period while
simultaneously maintaining a long
position in the security with the shares
acquired in a follow-on offering.22 To
cover the short sales, the person
instructed its prime broker to make
journal entries that cancelled out the
long and short positions through the use
20 See, e.g., SEC v. Graycort Financial, LLC, No.
C 06–6033 (NDCA Sept. 28, 2006); Litigation
Release No. 19851 (Sept. 28, 2006); Ascend Capital,
LLC, Exchange Act Release No. 48188 (July 17,
2003).
21 See, e.g., SEC v. Graycort Financial, LLC, No.
C 06–6033 (NDCA Sept. 28, 2006); SEC v. Galleon
Management, L.P., Litigation Release No. 19228
(May 19, 2005); Oaktree Capital Management LLC,
Exchange Act Release No. 51709 (May 19, 2005).
22 See id.
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of riskless, offsetting journal entries.23
Consequently, the offering shares were
used to cover the restricted period short
sale.
Each of these structures or strategies
we have observed seeks to replicate the
economic equivalent of the activity that
Rule 105 seeks to prevent. Additional
examples of strategies that have
developed over the years to conceal
conduct prohibited by Rule 105 include
arrangements to purchase from third
parties and married puts. The
Commission reiterated guidance
initially issued under Rule 10b–21(T),24
the predecessor to Rule 105, concerning
attempts to obscure violations through
indirect covering purchases using an
intermediary.25 In this situation, a short
sale is effected during the restricted
period and covered with offering
securities obtained through an
arrangement with a third party who
acquires the securities in the offering.
Through these types of transactions, the
trader is attempting to do indirectly
what he cannot do directly, i.e., the
covering prohibited by Rule 105.26
Section 20(b) of the Exchange Act makes
it ‘‘unlawful for any person, directly or
indirectly, to do any act or thing which
it would be unlawful for such person to
do * * * through or by means of any
other person.’’ 27
Further, the Commission noted its
concern about the abusive use of
married puts as part of trading strategies
designed to hide activity that violates
Rule 105. In this strategy, a married
put 28 is used to conceal the fact that the
sale effected during the restricted period
is a short sale. Essentially, this
technique is used to give the appearance
23 Id. (alleging Galleon established a 63,310 share
short position during the restricted period, received
a 95,000 share offering allocation, sold 31,690
shares, leaving a 63,310 share boxed position, and
thereafter instructed its prime broker to collapse the
63,310 share box).
24 See supra n.9.
25 Regulation SHO Adopting Release, 69 FR at
48021 (stating ‘‘[in] this transaction, the trader is
attempting to accomplish indirectly what he or she
cannot do directly, i.e., a type of short sale
transaction prohibited by Rule 105.’’); See also,
Exchange Act Release No. 26028 (Aug. 25, 1988),
53 FR 33455, 33458 (Aug. 31, 1988) (stating that
‘‘covering purchases effected by prearrangement or
other understanding through other purchasers in
the primary offering are proscribed through the
operation of section 20(b) of the Exchange Act,
which prohibits a person from doing indirectly any
act that he is prohibited from doing directly by the
Exchange Act or any rule thereunder.’’).
26 Id.
27 15 U.S.C. 78t(b).
28 The term ‘‘married put’’ is used to describe the
underlying transaction, i.e., the linked purchase of
securities and a put option to sell an equivalent
number of securities.
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that the restricted period sale was a long
sale, when in fact it was a short sale.29
This proposal is designed to further
provide confidence to issuers and
investors that offering prices would be
determined through the natural forces of
supply and demand and would not be
reduced by potentially manipulative
activity. Moreover, the proposal should
further provide confidence to persons
that they are making investment
decisions based on market prices and
offering prices unencumbered by
artificial forces.
III. Discussion of Proposed
Amendments
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In light of non-compliance with Rule
105, and the various strategies designed
to conceal conduct prohibited by Rule
105, we propose to amend Rule 105 to
prohibit any person from effecting a
restricted period short sale and then
purchasing, including entering into a
contract of sale for, the security in the
offering. A short sale is the sale of a
security that the seller does not own or
any sale that is consummated by the
delivery of a security borrowed by, or
for the account of, the seller.30 As we
have noted before, a person purchases,
including entering into a contract of sale
for, a security when the person becomes
29 Commission Guidance on Rule 3b–3 and
Married Put Transactions, Exchange Act Release
No. 48795 (Nov. 17, 2003), 68 FR 65820 (Nov. 21,
2003) (‘‘Married Puts Release’’) (stating ‘‘Most
recently, we have become aware of certain strategies
in which traders may acquire married puts as part
of what may be an effort to circumvent the
application of Rule 105. In these schemes traders
enter into married put transactions during the
restricted period 5 days before (or, sometimes, on
the day of) pricing in a ‘secondary’ or ‘repeat’
offering. Thereafter, the traders aggressively sell the
stock portion of the married put as ‘long’ sales,
exercise the puts at the end of the day they are
obtained, and then use securities obtained in the
offering (sometimes obtained at a discount to the
closing price) to cover their restricted period sales.
This activity often enables the traders receiving
offering shares to profit from the difference between
the sales prices and the offering price, where the
sales lowered the market price and, as a
consequence, the market-based offering price. Not
only is this manipulative conduct harmful to the
market, but it also may have a substantial impact
on the issuer and its security holders that receive
reduced offering proceeds as a result of the lower
offering price. We find the use of married put
transactions as a part of these strategies particularly
troubling because they represent an attempt to
facilitate the very kind of abuse that’’ Rule 105 is
designed to prevent.).
30 See 17 CFR 242.200. Although this definition
would remain unchanged for purposes of the
proposed amendment, for ease of reference, the
proposed rule text includes a reference to
Regulation SHO. We also removed the phrase ‘‘from
an underwriter or broker or dealer participating in
the offering’’ because Rule 105 now covers shelf
offerings and the phrase is no longer necessary.
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irrevocably committed to purchase the
security.31
Currently, Rule 105 makes it unlawful
for a person to cover a restricted period
short sale with offered securities.
Eliminating the covering component is
designed to end the progression of
schemes and structures engineered to
camouflage prohibited covering.
Otherwise, we would have to continue
to address each variation on a case-bycase basis, which could increase
uncertainty in the marketplace. The
proposal fosters the goals of Rule 105
and would be consistent with the
objectives of Regulation M—the
prevention of manipulation and the
facilitation of offering prices based on
the natural forces of supply and demand
unencumbered by artificial influence.
The proposal would promote market
integrity by precluding conduct that can
be manipulative around the time an
offering is priced so that market prices
can be fairly determined by supply and
demand. It would promote price
movements that result from natural
market forces, undistorted by artificial
forces. This would bolster investor
confidence in the capital raising
process. Further, the proposal would
protect issuers and selling security
holders from a specific and
demonstrated type of activity that can
reduce their offering proceeds.
As with the current rule, the proposal
would not ban short selling. The
proposal, like the current rule, would
allow short sales based on a person’s
view of a security’s future performance:
persons could effect short sales before
the restricted period and still purchase,
including enter into a contract of sale
for, the security in the offering, and
persons could effect short sales during
the restricted period and not purchase,
including enter into a contract of sale
for, the security in the offering.
However, the proposal does not provide
an exception to allow those that closeout restricted period short sales prior to
pricing to participate in the offering.
Finally, the proposal restructures the
rule in an effort to promote compliance
consistent with the prophylactic nature
of Regulation M.
As with current Rule 105,
responsibility for compliance with the
proposal would rest with the person
that effects a short sale during the
restricted period and purchases,
including enters into a contract of sale
for, the security in the offering
allocation. However, as with any
securities law, rule or regulation,
31 See Securities Offering Reform, Exchange Act
Release No. 52056 (July 19, 2005), 70 FR 44722,
44765 n.391 (Aug. 3, 2005).
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broker-dealers may be charged,
depending on the facts and
circumstances, for aiding and abetting
or causing securities law violations by
their customers.32 We encourage
commenters to discuss compliance
issues, including but not limited to, the
costs of compliance as well as any other
costs.
IV. Derivatives
In adopting Rule 105, the Commission
stated that Rule 105 does not apply to
short sales of derivative securities,
‘‘because an extension of the rule’s
prohibitions to derivative securities
would be inconsistent with the
approach of Regulation M, which is to
focus on those securities having the
greatest manipulative potential.’’ 33
Nonetheless, we understand that
persons may use options or other
derivatives in ways that may cause the
harm that Rule 105 is intended to
prevent. We request comment on
trading strategies involving derivatives
that may produce similar effects (e.g.,
depress the market prices of the
underlying equity security and result in
lower offering prices) in ways not
covered by the current or proposed rule.
Please provide specific detail regarding
the derivatives used, the transactions
employed, as well as the roles of the
various parties to the transactions.
Please describe whether a regulatory
approach that covers derivatives is over
inclusive or under inclusive and
provide alternative suggestions.
As with other rules, we note that the
use of derivatives as a part of trading
strategies designed to evade the
application of Rule 105 does not comply
with Commission rules.34 For example,
persons may attempt to circumvent Rule
105 by claiming to have a position in a
security by virtue of having entered into
a ‘‘married put’’ transaction when in
fact their transactions were the
equivalent of short sales, for which they
used shares acquired in the offering to
close-out their restricted period sales.35
Such conduct is proscribed through the
operation of section 20(b) of the
Exchange Act.36 The Commission has
32 See, generally, Exchange Act sections 15(b)(4),
20(a), 20(e), and 21C. See also Sharon M. Graham
and Stephen C. Voss v. SEC, 222 F.3d 994, 1007
(D.C. Cir. 2000).
33 Reg. M Adopting Release, 62 FR at 538.
34 See, e.g., Reg. M Adopting Release, 63 FR 538
(citing to Rule 10b–21 Adopting Release, 53 FR at
33457); Married Puts Release, 68 FR at 65820.
35 Married Puts Release, 68 FR at 65822
(discussing the operation of Rule 3b–3 with respect
to sellers who may claim to have a position in a
security by virtue of having entered into a ‘‘married
put’’ transaction).
36 15 U.S.C. 78t(b); see also, supra n.25.
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also noted that, ‘‘purchases effected by
prearrangement or other understanding
through other purchasers in the primary
offering are proscribed through the
operation of section 20(b) of the
Exchange Act, which prohibits a person
from doing indirectly any act that he is
prohibited from doing directly by the
Exchange Act or any rule
thereunder.’’ 37
V. Request for Comment
Q. The proposal provides that a
person who effects a restricted period
short sale cannot purchase, including
enter into a contract of sale for, the
security in the offering. As proposed,
the rule does not provide an exception
to allow those that cover restricted
period short sales prior to pricing to
participate in the offering. Should the
proposed rule provide an exception to
allow a person who effects a restricted
period short sale to purchase, including
enter into a contract of sale for, the
security in the offering if, after effecting
the restricted period short sale but
before pricing of the offering, the person
closes-out the entire short position in an
offered security with an open market
purchase during regular trading hours
that is reflected on the consolidated tape
or other reporting media? Please discuss
any alternatives, including whether the
rule should provide an exception to
allow a person who effects a restricted
period short sale to purchase, including
enter into a contract of sale for, the
security in the offering if, after effecting
the restricted period short sale but
before pricing of the offering, the person
can demonstrate, using required books
and records, that the person closed-out
the restricted period short sales (but not
necessarily the person’s entire short
position) with an open market purchase
during regular trading hours that is
reflected on the consolidated tape or
other reporting media. What would be
the appropriate time period in which to
close-out a person’s entire or restricted
period short position, i.e., 2 business
days before pricing? Would a shorter or
longer period be appropriate? If so,
please explain. Would such an
alternative address the abuses that the
rule is designed to prevent? Would such
an alternative prevent potential
transactions designed to disguise rule
violations? What is the frequency of
such trading? What difficulties would
be presented by not providing an
exception to allow persons to close-out
the short position? If the proposed rule
provides for such an exception, should
it also require that the person claiming
the exception be able to demonstrate
37 Rule
10b–21 Adopting Release, 53 FR at 33458.
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compliance? Are there other ways,
instead of an open market purchase
executed during regular trading hours
that is reflected on the consolidated tape
or other reporting media that a person
could use to close-out their entire or
restricted period short position that
would be transparent to the market prior
to pricing and should be considered?
What are the benefits of allowing a
person to close-out his entire or
restricted period short position after
effecting a restricted period short sale
but prior to pricing of the offering?
Q. Is the restricted period sufficient to
dissipate the effects of any manipulative
short selling on the price of the offered
security? Is there a longer or shorter
time frame or alternative measure that
would be more effective?
Q. Should the Rule 105(b) exception
for offerings that are not conducted on
a firm commitment basis be eliminated
or retained? If you believe that the
exception should be retained, please
describe why the manipulative abuse
that Rule 105 is designed to prevent is
not present in offerings conducted on
other than a firm commitment basis.
Q. In recent cases involving ‘‘Private
Investment in Public Equity’’ (‘‘PIPEs’’)
transactions, persons are alleged to have
agreed to invest in PIPE offerings, sold
short the issuer’s securities, and closedout the short position using shares
acquired from the issuer in the PIPE
transaction that are registered for resale
by such persons. Should the Rule
address short sales effected during the
period following the entering into of a
PIPE transaction and before a
registration statement for resale of the
restricted securities acquired in the PIPE
transaction is declared effective, or short
sales that are effected at any time in
connection with the PIPE transaction? Is
there an alternative period for which the
Rule should restrict short sales that
persons intend to close-out by using
shares acquired from the issuer in PIPE
transactions? What would be the impact
on issuers concerning short sales
effected in connection with PIPE
transactions if the Rule applied to
securities registered for resale in
connection with PIPEs transactions? For
example, what would be the effect on
issuers’ ability to attract PIPE investors
and the effect on the market for the
issuers’ securities?
Q. We are aware that short sales
effected prior to the exercise of
conversion rights, such as those under
a convertible debenture, can depress
stock prices and result in the issuance
of more shares upon the exercise of the
conversion rights. For example, a
convertible security such as a
convertible debenture may grant an
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investor the right to convert all or a
portion of the debenture into common
stock based on a formula using the price
of the common stock at the time of
conversion with the investor receiving
more shares on conversion if the market
price of the common stock declines. A
person may be liable under the antifraud provisions of the federal securities
laws if that person seeks to manipulate
the stock price downward to enhance
the economic interests in a convertible
security.38 Should Rule 105 address
short sales effected prior to the exercise
of conversion rights?
Q. Should Rule 105 apply to
issuances of rights to an issuer’s existing
security holders to buy a proportional
number of additional securities at a
given price (usually at a discount)
within a fixed period (a rights offering).
Is there a similar potential for persons
to influence the offer price through a
rights offering?
Q. Should the Rule address short sales
effected in connection with equity line
financing arrangements in which an
investor and a company enter into a
written agreement under which the
company has the right to put its
securities to the investor in an offering
in which the securities are registered for
sale or resale?
Q. Under the current and proposed
rule, an investor with a long position
can legally sell all or part of the position
during the five days prior to the offer
and still purchase shares in the offering.
We request comment on whether an
investor with a long position may have
the same economic incentives to
attempt this arbitrage or to manipulate
the price of the offer as a short seller.
Aside from legal risk, are the risks and
returns of the long strategy any different
from the risks and returns of the short
strategy? Can this strategy harm issuers?
Should the Commission consider
broadening Rule 105 to include long
sales?
Q. Rule 200(a) defines the term ‘‘short
sale’’ as any sale of a security that the
seller does not own or any sale that is
consummated by the delivery of a
security borrowed by, or for the account
of, the seller. Should the Commission
consider modifying this definition in
order to further the goals of this
proposal?
Q. Should Rule 105 apply to offerings
not made pursuant to a registration
statement on Form 1–A?
Q. Regulation E under the Securities
Act of 1933 provides certain small
business investment companies and
38 See, e.g., SEC v. Rhino Advisors, Inc. and
Thomas Badian, No. 03–CIV–1310 (SDNY 2003),
Litigation Release No. 18003 (Feb. 27, 2003).
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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?
Q. Would this proposal be more
effective than the existing rule in
deterring attempts to obscure violations
of Rule 105 and limiting manipulation
of offering prices?
Q. Rule 200(c) of Regulation SHO
states that, ‘‘[a] person shall be deemed
to own securities only to the extent that
he has a net long position in such
securities.’’ In order to determine the
net long position, a seller of an equity
security must aggregate all of that
person’s positions in that security.
Under Rule 200(f) of Regulation SHO,
however, a registered broker-dealer may
qualify for independent trading unit
aggregation. We seek comment about the
application of the aggregation principles
in the context of Rule 105 to non-brokerdealers, including, for example,
investment companies. Should nonbroker-dealers be provided an exception
similar to that provided to brokerdealers under Rule 200(f) of Regulation
SHO based on these aggregation
principles, e.g., should there be a
requirement that the non-broker dealer
be a registered investment adviser, or be
a client of a registered investment
adviser for purposes of the excepted
transaction? If so, what criteria would
be appropriate?
Q. Are there alternative approaches to
revising Rule 105 that should be
considered?
Q. Beyond selling short, are there
other types of trading strategies that
Rule 105 should address that similarly
exert untoward downward pressure on
a stock’s market price and thus lower
market prices prior to the pricing of
follow-on and secondary offerings? How
should such trading strategies be
addressed?
Q. Should potential investors in an
offering be required to give an
underwriter a certification that they
have not effected and will not effect a
short sale during the Rule 105 restricted
period? What are the costs and benefits
of such a requirement for investors and
underwriters? Would this impact the
costs of underwriting? Should any such
certification instead be provided to the
broker-dealer through which the person
is purchasing the shares?
Q. We request comment on any
liquidity or market efficiency impact
that the proposal may raise.
Q. Empirical evidence shows that, on
average, issuers decline in value by
about 3% when they announce an
impending public equity offering. Later,
issuers’ value declines another 1% to
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3% in the five days prior to the offer.
Following the offer, issuers’ value
recovers but the value five days after the
offer is still about 1⁄2% lower than the
value five days before the offer.39 We
request comment on any effect the
proposal will have on such price
patterns, i.e., the price of a security
declining prior to an offering and not
fully recovering. Is this price pattern
due to a type of evasion of Rule 105 that
the proposed amendment would
eliminate? Would these price patterns
change as a result of the proposal? Can
the 1⁄2% loss in issuers’ value be
considered an economic benefit of the
proposed amendment to Rule 105? Can
any of the 3% value decline at the
announcement of a public equity offer
be considered an economic benefit of
the proposed amendment to Rule 105?
Q. We request comment on any
impact the proposal may have on
trading and trading strategies.
Q. We request comment on any
impact the proposal may have on
dynamic hedging activities.
Q. To what extent, if any, will the
proposal increase or decrease the
potential for other types of
manipulation?
Q. Are there any technical or
operational challenges that would arise
in complying with the proposal?
Q. Does the proposal present any
special compliance difficulties or other
issues?
Q. How much would the amendments
affect specific compliance costs or other
costs for small, medium and large
entities?
Q. We request comment concerning
any effects that the proposal may have
on market participants, including
underwriters as well as specific effects
that the proposal may have on the
underwriting process.
Q. We request comment concerning
any effects that the proposal may have
on issuers, including the ability of
issuers to attract investors to their
securities offerings and the costs to
issuers of completing offerings.
Q. Would the proposed amendment
create additional costs for or otherwise
impact short sellers, issuers, investors,
underwriters, or others?
Q. What are the economic costs or
other costs associated with the
proposal?
General Request for Comments
The Commission seeks comment
generally on all aspects of the proposed
39 Several empirical studies report these price
patterns both before and after the application of
Rule 10b–21. See, e.g., Shane A. Corwin, The
Determinants of Underpricing for Seasoned Equity
Offers, 58 J. Fin. 2249 (Oct. 2003).
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amendment to Rule 105 of Regulation
M. Any interested persons wishing to
submit written comments on the
proposal, as well as other matters that
might have an impact on the proposal,
are requested to do so. Commenters are
requested to provide empirical data to
support their views and arguments
related to the proposal herein. In
addition to the questions posed above,
commenters are welcome to offer their
views on any other matter raised by the
proposed amendment to Rule 105. With
respect to any comments, we note that
they are of the greatest assistance to our
rulemaking initiative if accompanied by
supporting data and analysis of the
issues addressed in those comments and
by alternatives to our proposal where
appropriate.
VI. Paperwork Reduction Act
We have not prepared a submission to
the Office of Management and Budget
regarding the amendments to Rule 105
of Regulation M because the proposals
do not contain a collection of
information requirement within the
meaning of the Paperwork Reduction
Act of 1995.
VII. Consideration of Proposed
Amendments to Rule 105 of Regulation
M’s Costs and Benefits
The Commission is considering the
costs and benefits of the proposed
amendments to Rule 105. The
Commission is sensitive to costs and
benefits, requests data to quantify the
costs and the value of the benefits
provided, and encourages commenters
to discuss any additional costs or
benefits or reductions in costs beyond
those discussed here. Commenters
should provide analysis and data to
support their views on the costs and
benefits associated with the proposed
amendment. If applicable, the
Commission requests comments on the
potential costs for any modification to
computer systems and surveillance
mechanisms as well as any potential
benefits resulting from the proposal for
issuers, investors, broker or dealers,
other securities industry professionals,
regulators or other market participants.
A. Benefits
The proposal is intended to further
safeguard the integrity of the capital
raising process and protect issuers from
potentially manipulative activity that
can reduce issuers’ offering proceeds.
The proposal also is designed to provide
confidence to persons that they are
making investment decisions based on
market prices and offering prices
unencumbered by artificial forces.
Specifically, the proposal would
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prohibit a person who effects a short
sale during the Rule 105 restricted
period from purchasing, including
entering into a contract of sale for, the
security in an offering. The benefits of
the proposed modifications to Rule 105
would be realized by many market
participants, including investors,
issuers, selling security holders,
underwriters, short sellers and
regulators.
The proposed amendments to Rule
105 are intended to further facilitate
market prices and offering prices that
can be fairly determined by the natural
forces of supply and demand
undistorted by artificial forces.
Currently, Rule 105 makes it unlawful
for a person to cover a short sale
effected during the Rule’s restricted
period with certain offering securities.
The proposed amendment would
eliminate the covering component and
instead prohibit a person who effects a
short sale during the Rule’s restricted
period from purchasing, including
entering into a contract of sale for, the
security in an offering. The proposal is
intended to halt schemes designed to
conceal the prohibited covering. It also
provides a bright line demarcation of
prohibited activity consistent with the
prophylactic nature of Regulation M.
Issuers and selling security holders
should benefit from the proposal
because it is designed to promote the
goals of the current rule, enhancing
market integrity by precluding conduct
that can be manipulative around the
time an offering is priced so that market
prices can be fairly determined by
supply and demand. The proposal
should help issuers and selling security
holders realize proceeds that are not
artificially low due to short selling. The
proposal also would promote investor
confidence in the offering process,
which should foster capital formation.
In turn, these benefits should encourage
issuers to conduct capital formation in
the U.S. market.
Moreover, the proposed Rule 105
modifications retain much of the
flexibility of the current rule for traders
because persons continue to be able to
sell short during the restricted period if
they do not purchase, including enter
into a contract of sale for, the securities.
Persons also retain the ability to sell
short prior to the Rule 105 restricted
period and then purchase, including
enter into a contract of sale for, the
securities.
We believe the proposed modification
may reduce activity designed to disguise
rule violations. We believe this would
lead to a reduction in the number of
instances of aggressive short sellers
attempting to place artificial downward
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pressure on market prices. Therefore,
the proposal would strengthen the
ability of underwriters to set offering
prices without being encumbered by
artificial activities in the market.
We believe short sellers would benefit
from the proposal because it provides a
bright line test for Rule 105 compliance
consistent with the prophylactic nature
of Regulation M. The proposal does not
ban short selling. Indeed, it would allow
short sales that may contribute to
pricing efficiency and price discovery.
The bright line demarcation is
important because it would provide
clear guidance for short sellers seeking
to comply with Rule 105.
We believe the proposal may decrease
the level of non-compliance with the
Rule. The proposed elimination of the
Rule’s covering component should
reduce attempts to disguise the covering
activity through convoluted trading
structures. This would save significant
regulatory resources that would
otherwise be spent pursuing evolving
strategies to disguise conduct that
violates the Rule.
B. Costs
In complying with the proposed
modifications to Rule 105, a person that
effects a short sale during a defined
period could not purchase, including
enter into a contract of sale for, the
security in the offering. Under current
Rule 105, persons that effect short sales
during a restricted period cannot cover
their short position with the offering
securities. Thus, we believe any costs
currently associated with persons
reviewing their restricted period short
sales would remain the same, as a
person would use the current systems
and surveillance mechanisms for
information gathering, management, and
recordkeeping systems or procedures.
Indeed this proposal is intended to
provide a more straightforward means of
compliance.
As an aid in evaluating costs and
reductions in costs associated with the
proposed Rule 105 modifications, the
Commission requests the public’s views
and any supporting information. The
Commission believes that the proposed
amendments would impose negligible
costs, if any, on traders and issuers and
that the proposed amendments are
appropriate for the protection of
investors and issuers and to promote the
integrity of the capital raising process.
The Commission staff has noted that
investors desiring to participate in hot
issue offerings may improperly
accommodate an underwriter by
participating in a cold issue. Investors
may attempt to protect themselves
against losses in a cold issue by selling
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securities short in the Rule 105
restricted period intending to cover with
offering securities in violation of Rule
105.40 We seek comment about any
impact the proposal may have on the
underwriting process. If the proposal
impacts the underwriting process,
would it make it easier or more difficult
for underwriters to sell offerings and
what, if any, impact would there be on
efficiency of the pricing of an offering or
competition among underwriters?
The Commission encourages
commenters to discuss all costs. In
particular, the Commission requests
comment on the potential costs for any
modification to systems and
surveillance mechanisms, and for
information gathering, management, and
recordkeeping systems or procedures.
Commenters should provide analysis
and data to support their views on any
costs associated with the proposed
amendment.
VIII. Consideration of Burden on
Competition and Promotion of
Efficiency, Competition, and Capital
Formation
Section 3(f) of the Exchange Act
requires the Commission, whenever it
engages in rulemaking that requires it to
consider or determine if an action is
necessary or appropriate in the public
interest, to consider whether the action
would promote efficiency, competition,
and capital formation.41 In addition,
Section 23(a)(2) of the Exchange Act
requires the Commission, in adopting
rules under the Exchange Act, to
consider the anti-competitive effects of
any rules it adopts.42 Exchange Act
Section 23(a)(2) prohibits the
Commission from adopting any rule that
would impose a burden on competition
not necessary or appropriate in
furtherance of the purposes of the
Exchange Act.
The Commission preliminarily
believes that the proposed amendment
would promote capital formation
through improved integrity of the U.S.
securities markets by precluding
conduct that can depress security prices
during a critical period of time in the
capital raising process. Preventing the
type of potentially manipulative activity
targeted by the proposed amendment
would help protect the pricing process
so that the forces of supply and demand
are not undermined. The proposal
would promote price determinations
and movements that result from natural
market forces, undistorted by artificial
influences. We request comment on the
40 See
supra n.11.
U.S.C. 78c(f).
42 15 U.S.C. 78w(a)(2).
41 15
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impact of the amendment on capital
formation.
Short sales based upon a person’s
evaluation of the issuer’s fundamentals
(products, earnings, management, etc.)
and a security’s future performance may
contribute to pricing efficiency and
price discovery. Such short sales reflect
the value that a trader assigns to an
issuer’s security. However, short sales
prior to pricing an offering by a person
who expects an offering allocation and
anticipates making a quick profit from
effecting the short sale and then
purchasing, including entering into a
contract of sale for, the security in the
offering, may not similarly reflect the
trader’s evaluation of the issuer’s
fundamental value.
The Commission staff has noted that
investors desiring to participate in hot
issue offerings may improperly
accommodate an underwriter by
participating in a cold issue. Investors
may attempt to protect themselves
against losses in a cold issue by selling
securities short in the Rule 105
restricted period intending to cover with
offering securities in violation of Rule
105.43 We seek comment about any
impact the proposal may have on the
underwriting process. If the proposal
impacts the underwriting process,
would it make it easier or more difficult
for underwriters to sell offerings and
what, if any, impact would there be on
efficiency of the pricing of an offering or
competition among underwriters?
The Commission has considered the
proposal in light of the standards cited
in Section 23(a)(2) and believes
preliminarily that, if adopted, the
proposed amendments would not
impose a burden on competition not
necessary or appropriate in furtherance
of the purposes of the Exchange Act.
Specifically, the proposed version of the
Rule would continue to allow short
sales based on a person’s view of a
security’s future performance. Traders
could sell short before the restricted
period. Alternatively, traders could sell
short during the restricted period if they
do not purchase, including enter into a
contract of sale for, the securities. The
proposal would provide a bright line
approach designed to prevent improper
conduct and to provide a bright line
demarcation regarding conduct that is
prohibited for persons wishing to
comply with the rule.
The Commission generally requests
comment on the competitive or
anticompetitive effects of the proposed
amendments to Rule 105. The
Commission also requests comment on
what impact the proposed amendments
43 See
supra n.11.
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to Rule 105 would have on efficiency
and capital formation. Commenters
should provide analysis and empirical
data to support their views on the costs
and benefits associated with the
proposal.
IX. Consideration of Impact on the
Economy
For purposes of the Small Business
Regulatory Enforcement Fairness Act of
1996, or (SBREFA),44 we must advise
the Office of Management and Budget as
to whether the proposed amendments
constitute a ‘‘major’’ rule. Under
SBREFA, a rule is considered ‘‘major’’
where, if adopted, it results or is likely
to result in:
• An annual effect on the economy of
$100 million or more (either in the form
of an increase or a decrease);
• A major increase in costs or prices
for consumers or individual industries;
or
• Significant adverse effect on
competition, investment, or innovation.
If a rule is ‘‘major,’’ its effectiveness
will generally be delayed for 60 days
pending Congressional review. We
request comment on the potential
impact of the proposed amendments on
the economy on an annual basis.
Commenters are requested to provide
empirical data and other factual support
for their view to the extent possible.
X. Initial Regulatory Flexibility
Analysis
The Commission has prepared an
Initial Regulatory Flexibility Analysis
(IRFA), in accordance with the
provisions of the Regulatory Flexibility
Act (RFA) 45 regarding the proposed
amendment to Rule 105 of Regulation
M.
A. Reasons for the Proposed Action
The proposal is intended to safeguard
the integrity of the capital raising
process and further protect issuers from
potentially manipulative activity that
can reduce issuers’ offering proceeds.
There have been a number of Rule 105
cases brought by the Commission over
the last few years.46 The proposal would
provide a bright line test for Rule 105
compliance, which would be consistent
with the prophylactic nature of
Regulation M. The bright line
demarcation is important because it
provides clear guidance for persons
seeking to comply with Rule 105. We
believe the proposed bright line
44 Pub.
L. 104–121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C. and as a
note to 5 U.S.C. 601).
45 5 U.S.C. 603.
46 See supra n.17.
PO 00000
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Fmt 4701
Sfmt 4702
75009
demarcation would reduce Rule 105
violations.
Certain of the Commission’s recent
cases involved violations of Rule 105
that involved a complex series of
trading activity designed to obfuscate
the prohibited covering of restricted
period short positions with offered
shares. We have observed continuously
evolving strategies to obscure conduct
prohibited under Rule 105. Each scheme
seeks to replicate the economic
equivalent of the activity that Rule 105
seeks to prevent. We believe it is
important to eliminate the covering
component of the rule to cut off the
likely future development of more
complex attempts to disguise violations
of the Rule.
B. Objectives
The proposed amendments to Rule
105 would prohibit a person who effects
a short sale in the restricted period from
purchasing, including entering into a
contract of sale for, the security in an
offering. The proposal is designed to
promote the goals of the current rule,
enhancing market integrity by
precluding conduct that can be
manipulative around the time an
offering is priced so that market prices
can be fairly determined by supply and
demand. The proposal would promote
price movements that result from
natural market forces, undistorted by
artificial forces. Accordingly, we believe
the proposal would further safeguard
the integrity of the capital raising
process and protect issuers from
potentially manipulative activity that
can reduce issuers’ offering proceeds.
The proposal also would promote
investor confidence in the offering
process, which should foster capital
formation.
C. Legal Basis
The Commission is proposing to
amend Rule 105 pursuant to the
authority set forth in sections 7, 17(a),
and 19(a) of the Securities Act of 1933
[15 U.S.C. 77g, 77q(a), 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 Securities
Exchange Act of 1934 [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, 78mm];
and sections 23, 30, 38 of the
Investment Company Act [15 U.S.C.
80a–23, 80a–29, and 80a–37].
D. Small Entities Subject to the Rule
The proposed rule applies to any
person that effects a short sale during
the restricted period. This is unchanged
from the current rule. The entities
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covered by the proposed rule would
thus include small broker-dealers, small
businesses, and any investor eligible to
effect a short sale that qualifies as a
small entity.
Generally, these entities are already
subject to the current rule, which
contains requirements similar to those
in the proposed rule. As a result, the
marginal cost of compliance with the
proposed rule for these businesses is
likely to be minimal.
Although it is impossible to quantify
every type of small entity that may be
able to effect a short sale in a security,
Paragraph (c)(1) of Rule 0–10 47 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
§ 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 2005, the
Commission estimates that there were
approximately 910 broker dealers that
qualified as small entities as defined
above.48
Any business, however, regardless of
industry, could be subject to the
proposed rule if it effects a short sale.
The Commission believes that, except
for the broker-dealers discussed above,
an estimate of the number of small
entities that fall under the proposed rule
is not feasible.
E. Reporting, Recordkeeping and Other
Compliance Requirements
The proposed amendments to Rule
105 may impose limited new
compliance requirements on any
affected party, including broker-dealers
that are small entities. Under the
proposed amendments, market
participants could not purchase,
including enter into a contract of sale
for, the securities if they acquired a
short position in the security during a
restricted period. This proposal would
not modify the measurement of
restricted periods that apply, therefore,
since the current rule also addresses
conduct around short selling that occurs
during a restricted period, the
monitoring that would be required of
market participants to ensure
compliance with the amended Rule
would not change. The proposal does
47 17
CFR 240.0–10(c)(1).
numbers are based on the Office of
Economic Analysis’ review of 2005 FOCUS Report
filings reflecting registered broker dealers. This
number does not include brokeer-dealers that are
delinquent on FOCUS Report filings.
48 These
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20:10 Dec 12, 2006
Jkt 211001
not contain recordkeeping or reporting
requirements for broker-dealers.
F. Duplicative, Overlapping or
Conflicting Federal Rules
The Commission believes that there
are no federal rules that duplicate,
overlap or conflict with the proposed
amendments.
G. Significant Alternatives
The RFA directs the Commission to
consider significant alternatives that
would accomplish the stated objective,
while minimizing any significant
adverse impact on small issuers and
broker-dealers. Pursuant to Section 3(a)
of the RFA,49 the Commission
considered the following alternatives:
(1) The establishment of differing
compliance or reporting requirements or
timetables that take into account the
resources available to small entities; (2)
the clarification, consolidation, or
simplification of compliance and
reporting requirements under the Rule
for small entities; (3) the use of
performance rather than design
standards; and (4) an exemption from
coverage of the Rule, or any part thereof,
for small entities.
With respect to the proposed
amendments to Rule 105, the
Commission believes that, in order to
preclude conduct that can be
manipulative around the time an
offering is priced so that market prices
can be fairly determined by supply and
demand, uniform rules applicable to all
market participants (regardless of size)
are necessary. The Commission believes
that the establishment of different
requirements for small entities is neither
practicable nor in the public interest
because small entities can conduct the
same type of manipulative trading as
others. The proposed amendments
would likely impose minimal additional
costs, if any; therefore, establishing
different compliance requirements or
clarifying, consolidating, or simplifying
compliance or reporting requirements
for small entities would yield little or no
additional benefit. With regard to the
proposed amendments to Rule 105, and
clarification of the application of the
regulation, small entities would not be
specifically exempted, since all
securities may be subject to the type of
manipulation the amendments seek to
prevent. Finally, the proposed
amendments to Rule 105 would impose
performance standards rather than
design standards.
49 5
PO 00000
Fmt 4701
The Commission encourages written
comments on matters discussed in the
IRFA. In particular, the Commission
requests comments 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 (commenters are asked to
describe the nature of any impact and
provide 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. Such comments will be
considered in the preparation of the
Final Regulatory Flexibility Analysis, if
the proposed amendments are adopted,
and will be placed in the same public
file as comments on the proposed
amendments themselves. As discussed
above, for purposes of SBREFA, the
Commission is also requesting
information regarding the potential
impact of the proposed amendments on
the economy on an annual basis.
Commenters should provide empirical
data to support their views.
XI. Statutory Basis
The Commission is proposing to
amend Rule 105 pursuant to the
authority set forth in sections 7, 17(a),
and 19(a) of the Securities Act of 1933
[15 U.S.C. 77g, 77q(a), 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 Securities
Exchange Act of 1934 [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, 78mm];
and sections 23, 30, 38 of the
Investment Company Act [15 U.S.C.
80a–23, 80a–29, and 80a–37].
Text of Proposed Amendments
List of Subjects in 17 CFR Part 242
Brokers, Fraud, Reporting and
recordkeeping requirements, Securities.
In accordance with the foregoing,
Title 17, Chapter II, Part 242 of the Code
of Federal Regulations is proposed to be
amended as follows:
PART 242—REGULATIONS M, SHO,
ATS, AC, AND NMS AND CUSTOMER
MARGIN REQUIREMENTS FOR
SECURITY FUTURES
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,
U.S.C. 603(c).
Frm 00010
H. Solicitation of Comments
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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.
2. Section 242.105 is amended by
revising paragraph (a) to read as follows:
§ 242.105 Short selling in connection with
a public offering.
rwilkins on PROD1PC63 with PROPOSAL_2
(a) Unlawful Activity. In connection
with an offering of securities for cash
pursuant to a registration statement or a
notification on Form 1–A (§ 239.90 of
VerDate Aug<31>2005
20:10 Dec 12, 2006
Jkt 211001
this chapter) filed under the Securities
Act of 1933, it shall be unlawful for any
person to effect a short sale (as defined
in § 242.200) and then purchase,
including enter into a contract of sale
for, the security in the offering if that
person effected such short sale in the
offered security during the shorter of:
(1) The period beginning five business
days before the pricing of the offered
securities and ending with such pricing;
or
PO 00000
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75011
(2) The period beginning with the
initial filing of such registration
statement or notification on Form 1–A
and ending with the pricing.
*
*
*
*
*
Dated: December 6, 2006.
By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. E6–21141 Filed 12–12–06; 8:45 am]
BILLING CODE 8011–01–P
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]]>Agencies
[Federal Register Volume 71, Number 239 (Wednesday, December 13, 2006)]
[Proposed Rules]
[Pages 75002-75011]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-21141]
[[Page 75001]]
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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; Proposed Rule
Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 /
Proposed Rules
[[Page 75002]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-54888; File No. S7-20-06]
RIN 3235-AJ75
Short Selling in Connection With a Public Offering
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing amendments to Regulation M concerning the anti-manipulation
rules for securities offerings that would further safeguard the
integrity of the capital raising process and protect issuers from
manipulative activity that can reduce issuers' offering proceeds and
dilute security holder value. The proposal would prevent a person from
effecting a short sale during a limited time period, shortly before
pricing, and then purchasing, including entering into a contract of
sale for, such security in the offering.
DATES: Comments should be received on or before February 12, 2007
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (https://
www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File No. S7-20-06 on the subject line; or
Use the Federal eRulemaking Portal (https://
www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-20-06. This file
number should be included on the subject line if e-mail is used. To
help us process and review your comments more efficiently, please use
only one method. The Commission will post all comments on the
Commission's Internet Web site (https://www.sec.gov/rules/
proposed.shtml). Comments are also available for public inspection and
copying in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549. All comments received will be posted without
change; we do not edit personal identifying information from
submissions. You should submit only information that you wish to make
publicly available.
FOR FURTHER INFORMATION CONTACT: James A. Brigagliano, Acting Associate
Director, Josephine Tao, Branch Chief, Elizabeth Sandoe, Victoria
Crane, and Marlon Quintanilla Paz, Special Counsels, (202) 551-5720,
Office of Trading Practices and Processing, Division of Market
Regulation, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-6628.
SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed amendments to Rule 105 of Regulation M [17 CFR 242.105].
Table Of Contents
I. Introduction
II. Background
III. Discussion of Proposed Amendments
IV. Derivatives
V. Request for Comment
VI. Paperwork Reduction Act
VII. Consideration of Proposed Amendments to Rule 105 of Regulation
M's Costs and Benefits
A. Benefits
B. Costs
VIII. Consideration of Burden on Competition and Promotion of
Efficiency, Competition, and Capital Formation
IX. Consideration of Impact on the Economy
X. Initial Regulatory Flexibility Analysis
A. Reasons for the Proposed Action
B. Objectives
C. Legal Basis
D. Small Entities Subject to the Rule
E. Reporting, Recordkeeping and Other Compliance Requirements
F. Duplicative, Overlapping or Conflicting Federal Rules
G. Significant Alternatives
H. Solicitation of Comments
XI. Statutory Basis
I. Introduction
A fundamental goal of Regulation M, Anti-manipulation Rules
Concerning Securities Offerings, is protecting the independent pricing
mechanism of the securities markets so that offering prices result from
the natural forces of supply and demand unencumbered by artificial
forces.\1\ Price integrity is essential in the offering process.
Regulation M is intended to foster price integrity by prohibiting
activity that interferes with independent market dynamics, prior to
pricing offerings, by persons with a heightened incentive to
manipulate.
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\1\ Securities Exchange Act of 1934 (``Exchange Act'') Release
No. 38067 (Dec. 20, 1996), 62 FR 520 (Jan. 3, 1997) (``Regulation M
Adopting Release'').
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Regulation M consists of a definitional rule, Rule 100, and five
additional rules, Rules 101 through 105.\2\ Rule 105, Short Selling In
Connection With A Public Offering, prohibits a person from covering a
short sale \3\ with securities sold in the offering, if such person
sold short within five days prior to pricing or the period beginning
with the filing of the registration statement and ending with pricing,
whichever is shorter. This short selling can artificially depress
market prices which can lead to lower than anticipated offering prices,
thus causing an issuer's offering proceeds to be reduced.\4\
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\2\ 17 CFR 242.100 through 242.105.
\3\ A short sale is the sale of a security that the seller does
not own or any sale that is consummated by the delivery of a
security borrowed by, or for the account of, the seller. See 17 CFR
242.200 (2006).
\4\ See Regulation M Adopting Release, 62 FR at 538.
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We are aware of non-compliance with current Rule 105, and in some
cases, strategies used to disguise Rule 105 violations.\5\ Despite
interpretive guidance regarding the application of Rule 105,\6\ we have
witnessed 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.
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\5\ See infra n.18.
\6\ See Exchange Act Release No. 50103 (July 28, 2004), 69 FR
48008, 48020-21 (Aug. 6, 2004) (``Regulation SHO Adopting
Release'').
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We propose amending Rule 105 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. The proposal, like the current rule, provides a bright
line test for Rule 105 compliance consistent with the prophylactic
nature of Regulation M. In light of evidence of non-compliance with the
current rule, we believe the proposal would promote investor and issuer
confidence in pricing integrity and in the offering process, which
should facilitate capital formation. In addition, the elimination of
the current rule's covering component is intended to address attempts
to restructure transactions in an effort to evade Rule 105.
The proposal is narrowly tailored to address short sales prior to
pricing that can reduce issuers' offering proceeds without restricting
other short sales before the offering.\7\ Like the current rule, the
proposal would permit persons that effect short sales prior to the
restricted period to purchase, including to enter into a contract of
sale for, such security in the offering and would
[[Page 75003]]
permit persons to sell short during the restricted period if they do
not purchase, including enter into a contract of sale for, such
security in the offering.
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\7\ If the registered offering is on behalf of selling security
holders, the proceeds of such selling security holders can be
similarly reduced.
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We solicit specific comment on our approach and the specific
proposals. We encourage commenters to present data on our proposals and
any suggested alternative approaches.
II. Background
The Commission has long been concerned that short sales effected
prior to certain offerings that are covered with offering securities
can be manipulative conduct harmful to the market and can have a
substantial impact on issuers or selling security holders. Rule 10b-
21,\8\ the predecessor to Rule 105, prohibited covering short sales
with offering securities if the short sale took place during the period
beginning at the time that the registration statement or Form 1-A was
filed and ending at the time that sales may be made pursuant to the
registration statement or Form 1-A.\9\ The Commission stated that Rule
10b-21 would ``help deter a practice that the Commission views as
manipulative and destructive of issuers' capital raising activities.''
\10\
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\8\ Rule 10b-21 was rescinded with the adoption of Regulation M.
Regulation M Adopting Release, 62 FR at 520.
\9\ Exchange Act Release No. 33702 (Mar. 2, 1994), 59 FR 10984
(Mar. 9, 1994) (``Rule 10b-21 Adopting Release''). Rule 10b-21(T)
was initially adopted on a temporary basis. Exchange Act Release No.
26028 (Aug. 31, 1988), 53 FR 33455 (Aug. 31, 1988). The Commission
proposed the rule for public comment in 1987. Exchange Act Release
No. 24485 (May 20, 1987), 52 FR 19885 (May 28, 1987) (``1987
Proposing Release''). The Commission proposed three versions of Rule
10b-21 prior to the 1987 Proposing Release. See Exchange Act Release
No. 10636 (Feb. 11, 1974), 39 FR 7806 (Feb. 28, 1974); Exchange Act
Release No. 11328 (Apr. 2, 1975), 40 FR 16090 (Apr. 9, 1975);
Exchange Act Release No. 13092 (Dec. 21, 1976), 41 FR 56542 (Dec.
28, 1976).
Rule 10b-21 provided that, ``It shall be unlawful for any person
who effects one or more short sales of equity securities of the same
class as securities offered for cash pursuant to a registration
statement filed under the Securities Act of 1933 (`Securities Act')
or pursuant to a notification on Form 1-A under the Securities Act
(`offered securities'), to cover such short sale or sales with
offered securities purchased from an underwriter or broker or dealer
participating in the offering, if such short sales or sale took
place during the period beginning at the time that the registration
statement or Form 1-A is filed and ending at the time that sales may
be made pursuant to the registration statement or Form 1-A.'' Former
Rule 10b-21(a).
\10\ 53 FR at 33456.
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Prior to Rule 10b-21's adoption, the Commission noted the staff's
view about short selling prior to an offering, stating that ``it
appears that such short selling prior to the offering date has had a
substantial adverse impact on the market price of the securities and in
some instances has caused the offerings to be postponed temporarily, to
be abandoned completely, or to be made at prices lower than originally
intended--prices which do not reflect the market value of the
securities, undistorted by artificial factors.'' \11\
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\11\ Exchange Act Release No. 9824 (Oct. 25, 1972), 37 FR 22796
(Oct. 25, 1972). In addition, the Commission noted the staff's view
that ``Such investors and broker-dealers, desiring to participate in
so-called `hot' issue offerings, agree to accommodate the
underwriters and therefore participate in the so-called `cold'
issue. Such persons reportedly then attempt to protect themselves
against losses by selling the securities short prior to the
distribution, intending to cover their position with the securities
being offered.'' 37 FR at 22796.
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Generally, the offering prices of follow-on and secondary offerings
\12\ are priced at a discount to a stock's closing price (depending on
the exchange, the closing transaction price, closing bid price, or last
sale 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 price with securities received through an allocation. 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.\13\ Short sales during the
period immediately preceding pricing an offering can exert downward
pressure upon a stock's price that can result in lower offering prices.
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\12\ The first time an issuer conducts a public offering of its
securities, the offering is referred to as an initial public
offering (``IPO''). Subsequent offerings by the issuer are referred
to as follow-on offerings or repeat offerings. A secondary offering
is an offering of securities held by security holders, for which
there already exist trading markets for the same class of securities
as those being offered. See Exchange Act Release No 10636 (Feb. 11,
1974), 39 FR 7806 n.1 (Feb. 28, 1974). Of course, IPOs also may
include secondary offerings by selling security holders.
\13\ Of course, there are additional risks including execution
risk, quantity risk and litigation risk that the short seller might
consider. Based on our experience, it would appear that many
investors perceive these risks as minimal because they do not appear
to deter this shorting strategy. The shorting strategy is detailed
in a number of enforcement cases concerning Rule 105. See infra
n.18.
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Some persons may decide to sell short prior to the pricing of an
offering because they believe the security is overpriced. This activity
provides a true price discovery mechanism for the market and should be
encouraged. Persons who are attempting to capture the offer price
discount are not selling short the security because the security is
overpriced; thus, they do not contribute to true pricing
efficiency.\14\ Instead, by selling the security short with the
knowledge that they are very likely to be able to cover their short
positions with offering shares that they are allocated, these persons
may drive down the price despite their true belief regarding the
appropriate price for that security. The likelihood of being allocated
offering shares provides these persons with an advantage over other
persons, which they may exploit to the detriment of pricing efficiency.
Not only is this conduct harmful to the market and current security
holders, but it can reduce the proceeds the issuer or the selling
security holder receives from the securities offering.
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\14\ ``The Commission has also cautioned that 'any person
intending to purchase securities in any registered secondary
offering should be on notice that his selling short the same
securities prior to the offering may be subject to the registration
requirements of Section 5 of the Securities Act [15 U.S.C. 77e] as
well as other applicable statutes and rules.' Exchange Act Release
No. 10636 (Feb. 11, 1974). Accord, Exchange Act Release Nos. 11328
n. 1 (Apr. 2, 1975) and 9824 (Oct. 16, 1972).'' Exchange Act Release
No. 26028 (Aug. 25, 1988), 53 FR 3345, 33457 (Aug. 31, 1988).
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To facilitate true price discovery, Rule 105 governs short sales
immediately prior to pricing follow-on and secondary offerings where
the short sales are covered with offering securities.\15\ Currently,
Rule 105 prohibits persons from covering a short sale with offering
securities if the short sale occurred during a Rule 105 restricted
period. Typically, the Rule 105 restricted period begins five business
days before the pricing of the offering and ends with pricing.\16\ Rule
105 is prophylactic. Thus, its prohibitions apply irrespective of a
short seller's intent.\17\ Rule 105 does not ban short sales because
certain short sales may be motivated by a short seller's evaluation of
a security's future performance and contribute to pricing efficiency
and price discovery. The rule does not unduly restrict short selling,
and thus does not hamper true price discovery, because persons are not
prohibited from short selling and persons expecting to receive
allocation
[[Page 75004]]
of offering shares can effect short sales prior to the Rule 105
restricted period. In addition, short sales can be made during the
restricted period if the seller does not cover with shares it receives
in the offering.
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\15\ 17 CFR 242.105. Short selling in connection with a public
offering. (a) Unlawful Activity. In 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 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 such pricing.
\16\ See id.
\17\ See Exchange Act Release No. 48795 (Nov. 17, 2003), 68 FR
65820, 65822 n.22 (Nov. 21, 2003) (stating that Rule 105 does not
require a showing of scienter). Short sales effected during the Rule
105 restricted period can depress market prices and reduce an
issuer's offering proceeds even if the short seller has no
manipulative intent.
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There has been non-compliance with Rule 105 and examples are
detailed in numerous recent Commission enforcement cases.\18\ We have
seen patterns where persons engage in strategies to avoid the
appearance that offering shares they were allocated are used to cover
Rule 105 restricted period short sales. Whether trading strategies are
the product of attempts to avoid application of the rule or attempts to
conceal Rule 105 violations, they indicate the presence of activity
that the rule is designed to prevent.
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\18\ See, e.g., SEC v. Solar Group S.A. and James J. Todd, No.
06-CV-12936 (SDNY Nov. 6, 2006), Litigation Release No. 19899 (Nov.
6, 2006); SEC v. Graycort Financial, LLC, No. C 06-6033 (NDCA Sept.
28, 2006), Litigation Release No. 19851 (Sept. 28, 2006); SEC v.
Compania Internacional Financiera SA and Yomi Rodrig, No. 05-CV-
10634 (SDNY Dec. 20, 2005), Litigation Release No. 19501 (Dec. 20,
2005); SEC v. Galleon Management, L.P., Litigation Release No. 19228
(May 19, 2005); DB Investment Managers, Inc., Exchange Act Release
No. 51707 (May 19, 2005); Oaktree Capital Management LLC, Exchange
Act Release No. 51709 (May 19, 2005); SEC v. Joseph X. Crivelli,
Exchange Act Release No. 50092 (July 27, 2004); Ascend Capital, LLC,
Exchange Act Release No. 48188 (July 17, 2003); and SEC v. Ethan H.
Weitz and Robert R. Altman, Litigation Release No. 18121 (Apr. 30,
2003).
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Certain of the cases illustrate activity meant to obfuscate the
prohibited covering. One method of obscuring a Rule 105 violation
involves post-offering sales and purchases undertaken to give the
appearance that the restricted period short sales were covered with
shares other than the offering allocation. For example, a person (1)
effects a short sale of 5,000 shares during a Rule 105 restricted
period, (2) purchases, including enters into a contract of sale for,
5,000 shares of the security in the offering, (3) following the
purchase, or entry into the contract of sale, sells 5,000 shares and
(4) contemporaneously or nearly contemporaneously purchases 5,000
shares. The Rule 105 violation may be complete when the restricted
period short sale is covered with offering shares at step number 2
above. Once the restricted period short sale is executed and the person
purchases, including enters into a contract of sale for, the offered
securities, the position is economically flat. A contemporaneous or
nearly contemporaneous post-offering purchase and sale does not undo
the Rule 105 violation.\19\ In that situation, a person may violate
Rule 105 despite his or her claim that the market purchase following
the offering, rather than the shares acquired in the offering, covered
the short position because there is no legitimate economic purpose or
substance to the contemporaneous purchase and sale, no genuine change
in beneficial ownership, and/or little or no market risk.
---------------------------------------------------------------------------
\19\ The Commission issued interpretive guidance regarding
transactions that are engineered to obfuscate a Rule 105 violation.
69 FR at 48021.
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Certain Commission enforcement cases illustrate variations of this
tactic. The following examples illustrate attempted concealments of
covering through the use of crossed limit orders and the use of market
orders. Persons may claim that a post-allocation shares purchase,
rather than the shares from the offering allocation, are used to cover
the restricted period short sale. However, this post offering activity
may be an attempt to conceal the prohibited covering after the Rule 105
violation has occurred.
The Commission has settled proceedings in which respondents covered
restricted period short positions in violation of Rule 105 and placed
post-offering limit orders to sell and purchase the offered security at
the same price and in the same quantity.\20\ For example, 1,000 shares
of an issuer's common stock were sold short during the restricted
period. Next, the person purchased, including entered into a contract
of sale for, 1,000 shares of the security in the offering. Thereafter,
buy and sell limit orders were placed to ``cross'' 1,000 shares of the
issuer within the same account. Subsequently, the Commission has
settled cases in which the respondents effected a post-offering sale
and purchase of securities with market orders filled at nearly the same
price.\21\
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\20\ See, e.g., SEC v. Graycort Financial, LLC, No. C 06-6033
(NDCA Sept. 28, 2006); Litigation Release No. 19851 (Sept. 28,
2006); Ascend Capital, LLC, Exchange Act Release No. 48188 (July 17,
2003).
\21\ See, e.g., SEC v. Graycort Financial, LLC, No. C 06-6033
(NDCA Sept. 28, 2006); SEC v. Galleon Management, L.P., Litigation
Release No. 19228 (May 19, 2005); Oaktree Capital Management LLC,
Exchange Act Release No. 51709 (May 19, 2005).
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Another strategy to obfuscate the prohibited covering is a practice
known as ``collapsing the box.'' In one Commission settled case, for
example, a person created ``boxed'' positions by maintaining a short
position established during the restricted period while simultaneously
maintaining a long position in the security with the shares acquired in
a follow-on offering.\22\ To cover the short sales, the person
instructed its prime broker to make journal entries that cancelled out
the long and short positions through the use of riskless, offsetting
journal entries.\23\ Consequently, the offering shares were used to
cover the restricted period short sale.
---------------------------------------------------------------------------
\22\ See id.
\23\ Id. (alleging Galleon established a 63,310 share short
position during the restricted period, received a 95,000 share
offering allocation, sold 31,690 shares, leaving a 63,310 share
boxed position, and thereafter instructed its prime broker to
collapse the 63,310 share box).
---------------------------------------------------------------------------
Each of these structures or strategies we have observed seeks to
replicate the economic equivalent of the activity that Rule 105 seeks
to prevent. Additional examples of strategies that have developed over
the years to conceal conduct prohibited by Rule 105 include
arrangements to purchase from third parties and married puts. The
Commission reiterated guidance initially issued under Rule 10b-
21(T),\24\ the predecessor to Rule 105, concerning attempts to obscure
violations through indirect covering purchases using an
intermediary.\25\ In this situation, a short sale is effected during
the restricted period and covered with offering securities obtained
through an arrangement with a third party who acquires the securities
in the offering. Through these types of transactions, the trader is
attempting to do indirectly what he cannot do directly, i.e., the
covering prohibited by Rule 105.\26\ Section 20(b) of the Exchange Act
makes it ``unlawful for any person, directly or indirectly, to do any
act or thing which it would be unlawful for such person to do * * *
through or by means of any other person.'' \27\
---------------------------------------------------------------------------
\24\ See supra n.9.
\25\ Regulation SHO Adopting Release, 69 FR at 48021 (stating
``[in] this transaction, the trader is attempting to accomplish
indirectly what he or she cannot do directly, i.e., a type of short
sale transaction prohibited by Rule 105.''); See also, Exchange Act
Release No. 26028 (Aug. 25, 1988), 53 FR 33455, 33458 (Aug. 31,
1988) (stating that ``covering purchases effected by prearrangement
or other understanding through other purchasers in the primary
offering are proscribed through the operation of section 20(b) of
the Exchange Act, which prohibits a person from doing indirectly any
act that he is prohibited from doing directly by the Exchange Act or
any rule thereunder.'').
\26\ Id.
\27\ 15 U.S.C. 78t(b).
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Further, the Commission noted its concern about the abusive use of
married puts as part of trading strategies designed to hide activity
that violates Rule 105. In this strategy, a married put \28\ is used to
conceal the fact that the sale effected during the restricted period is
a short sale. Essentially, this technique is used to give the
appearance
[[Page 75005]]
that the restricted period sale was a long sale, when in fact it was a
short sale.\29\
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\28\ The term ``married put'' is used to describe the underlying
transaction, i.e., the linked purchase of securities and a put
option to sell an equivalent number of securities.
\29\ Commission Guidance on Rule 3b-3 and Married Put
Transactions, Exchange Act Release No. 48795 (Nov. 17, 2003), 68 FR
65820 (Nov. 21, 2003) (``Married Puts Release'') (stating ``Most
recently, we have become aware of certain strategies in which
traders may acquire married puts as part of what may be an effort to
circumvent the application of Rule 105. In these schemes traders
enter into married put transactions during the restricted period 5
days before (or, sometimes, on the day of) pricing in a `secondary'
or `repeat' offering. Thereafter, the traders aggressively sell the
stock portion of the married put as `long' sales, exercise the puts
at the end of the day they are obtained, and then use securities
obtained in the offering (sometimes obtained at a discount to the
closing price) to cover their restricted period sales. This activity
often enables the traders receiving offering shares to profit from
the difference between the sales prices and the offering price,
where the sales lowered the market price and, as a consequence, the
market-based offering price. Not only is this manipulative conduct
harmful to the market, but it also may have a substantial impact on
the issuer and its security holders that receive reduced offering
proceeds as a result of the lower offering price. We find the use of
married put transactions as a part of these strategies particularly
troubling because they represent an attempt to facilitate the very
kind of abuse that'' Rule 105 is designed to prevent.).
---------------------------------------------------------------------------
This proposal is designed to further provide confidence to issuers
and investors that offering prices would be determined through the
natural forces of supply and demand and would not be reduced by
potentially manipulative activity. Moreover, the proposal should
further provide confidence to persons that they are making investment
decisions based on market prices and offering prices unencumbered by
artificial forces.
III. Discussion of Proposed Amendments
In light of non-compliance with Rule 105, and the various
strategies designed to conceal conduct prohibited by Rule 105, we
propose to amend Rule 105 to prohibit any person from effecting a
restricted period short sale and then purchasing, including entering
into a contract of sale for, the security in the offering. A short sale
is the sale of a security that the seller does not own or any sale that
is consummated by the delivery of a security borrowed by, or for the
account of, the seller.\30\ As we have noted before, a person
purchases, including entering into a contract of sale for, a security
when the person becomes irrevocably committed to purchase the
security.\31\
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\30\ See 17 CFR 242.200. Although this definition would remain
unchanged for purposes of the proposed amendment, for ease of
reference, the proposed rule text includes a reference to Regulation
SHO. We also removed the phrase ``from an underwriter or broker or
dealer participating in the offering'' because Rule 105 now covers
shelf offerings and the phrase is no longer necessary.
\31\ See Securities Offering Reform, Exchange Act Release No.
52056 (July 19, 2005), 70 FR 44722, 44765 n.391 (Aug. 3, 2005).
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Currently, Rule 105 makes it unlawful for a person to cover a
restricted period short sale with offered securities. Eliminating the
covering component is designed to end the progression of schemes and
structures engineered to camouflage prohibited covering. Otherwise, we
would have to continue to address each variation on a case-by-case
basis, which could increase uncertainty in the marketplace. The
proposal fosters the goals of Rule 105 and would be consistent with the
objectives of Regulation M--the prevention of manipulation and the
facilitation of offering prices based on the natural forces of supply
and demand unencumbered by artificial influence. The proposal would
promote market integrity by precluding conduct that can be manipulative
around the time an offering is priced so that market prices can be
fairly determined by supply and demand. It would promote price
movements that result from natural market forces, undistorted by
artificial forces. This would bolster investor confidence in the
capital raising process. Further, the proposal would protect issuers
and selling security holders from a specific and demonstrated type of
activity that can reduce their offering proceeds.
As with the current rule, the proposal would not ban short selling.
The proposal, like the current rule, would allow short sales based on a
person's view of a security's future performance: persons could effect
short sales before the restricted period and still purchase, including
enter into a contract of sale for, the security in the offering, and
persons could effect short sales during the restricted period and not
purchase, including enter into a contract of sale for, the security in
the offering. However, the proposal does not provide an exception to
allow those that close-out restricted period short sales prior to
pricing to participate in the offering.
Finally, the proposal restructures the rule in an effort to promote
compliance consistent with the prophylactic nature of Regulation M.
As with current Rule 105, responsibility for compliance with the
proposal would rest with the person that effects a short sale during
the restricted period and purchases, including enters into a contract
of sale for, the security in the offering allocation. However, as with
any securities law, rule or regulation, broker-dealers may be charged,
depending on the facts and circumstances, for aiding and abetting or
causing securities law violations by their customers.\32\ We encourage
commenters to discuss compliance issues, including but not limited to,
the costs of compliance as well as any other costs.
---------------------------------------------------------------------------
\32\ See, generally, Exchange Act sections 15(b)(4), 20(a),
20(e), and 21C. See also Sharon M. Graham and Stephen C. Voss v.
SEC, 222 F.3d 994, 1007 (D.C. Cir. 2000).
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IV. Derivatives
In adopting Rule 105, the Commission stated that Rule 105 does not
apply to short sales of derivative securities, ``because an extension
of the rule's prohibitions to derivative securities would be
inconsistent with the approach of Regulation M, which is to focus on
those securities having the greatest manipulative potential.'' \33\
Nonetheless, we understand that persons may use options or other
derivatives in ways that may cause the harm that Rule 105 is intended
to prevent. We request comment on trading strategies involving
derivatives that may produce similar effects (e.g., depress the market
prices of the underlying equity security and result in lower offering
prices) in ways not covered by the current or proposed rule. Please
provide specific detail regarding the derivatives used, the
transactions employed, as well as the roles of the various parties to
the transactions. Please describe whether a regulatory approach that
covers derivatives is over inclusive or under inclusive and provide
alternative suggestions.
---------------------------------------------------------------------------
\33\ Reg. M Adopting Release, 62 FR at 538.
---------------------------------------------------------------------------
As with other rules, we note that the use of derivatives as a part
of trading strategies designed to evade the application of Rule 105
does not comply with Commission rules.\34\ For example, persons may
attempt to circumvent Rule 105 by claiming to have a position in a
security by virtue of having entered into a ``married put'' transaction
when in fact their transactions were the equivalent of short sales, for
which they used shares acquired in the offering to close-out their
restricted period sales.\35\ Such conduct is proscribed through the
operation of section 20(b) of the Exchange Act.\36\ The Commission has
[[Page 75006]]
also noted that, ``purchases effected by prearrangement or other
understanding through other purchasers in the primary offering are
proscribed through the operation of section 20(b) of the Exchange Act,
which prohibits a person from doing indirectly any act that he is
prohibited from doing directly by the Exchange Act or any rule
thereunder.'' \37\
---------------------------------------------------------------------------
\34\ See, e.g., Reg. M Adopting Release, 63 FR 538 (citing to
Rule 10b-21 Adopting Release, 53 FR at 33457); Married Puts Release,
68 FR at 65820.
\35\ Married Puts Release, 68 FR at 65822 (discussing the
operation of Rule 3b-3 with respect to sellers who may claim to have
a position in a security by virtue of having entered into a
``married put'' transaction).
\36\ 15 U.S.C. 78t(b); see also, supra n.25.
\37\ Rule 10b-21 Adopting Release, 53 FR at 33458.
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V. Request for Comment
Q. The proposal provides that a person who effects a restricted
period short sale cannot purchase, including enter into a contract of
sale for, the security in the offering. As proposed, the rule does not
provide an exception to allow those that cover restricted period short
sales prior to pricing to participate in the offering. Should the
proposed rule provide an exception to allow a person who effects a
restricted period short sale to purchase, including enter into a
contract of sale for, the security in the offering if, after effecting
the restricted period short sale but before pricing of the offering,
the person closes-out the entire short position in an offered security
with an open market purchase during regular trading hours that is
reflected on the consolidated tape or other reporting media? Please
discuss any alternatives, including whether the rule should provide an
exception to allow a person who effects a restricted period short sale
to purchase, including enter into a contract of sale for, the security
in the offering if, after effecting the restricted period short sale
but before pricing of the offering, the person can demonstrate, using
required books and records, that the person closed-out the restricted
period short sales (but not necessarily the person's entire short
position) with an open market purchase during regular trading hours
that is reflected on the consolidated tape or other reporting media.
What would be the appropriate time period in which to close-out a
person's entire or restricted period short position, i.e., 2 business
days before pricing? Would a shorter or longer period be appropriate?
If so, please explain. Would such an alternative address the abuses
that the rule is designed to prevent? Would such an alternative prevent
potential transactions designed to disguise rule violations? What is
the frequency of such trading? What difficulties would be presented by
not providing an exception to allow persons to close-out the short
position? If the proposed rule provides for such an exception, should
it also require that the person claiming the exception be able to
demonstrate compliance? Are there other ways, instead of an open market
purchase executed during regular trading hours that is reflected on the
consolidated tape or other reporting media that a person could use to
close-out their entire or restricted period short position that would
be transparent to the market prior to pricing and should be considered?
What are the benefits of allowing a person to close-out his entire or
restricted period short position after effecting a restricted period
short sale but prior to pricing of the offering?
Q. Is the restricted period sufficient to dissipate the effects of
any manipulative short selling on the price of the offered security? Is
there a longer or shorter time frame or alternative measure that would
be more effective?
Q. Should the Rule 105(b) exception for offerings that are not
conducted on a firm commitment basis be eliminated or retained? If you
believe that the exception should be retained, please describe why the
manipulative abuse that Rule 105 is designed to prevent is not present
in offerings conducted on other than a firm commitment basis.
Q. In recent cases involving ``Private Investment in Public
Equity'' (``PIPEs'') transactions, persons are alleged to have agreed
to invest in PIPE offerings, sold short the issuer's securities, and
closed-out the short position using shares acquired from the issuer in
the PIPE transaction that are registered for resale by such persons.
Should the Rule address short sales effected during the period
following the entering into of a PIPE transaction and before a
registration statement for resale of the restricted securities acquired
in the PIPE transaction is declared effective, or short sales that are
effected at any time in connection with the PIPE transaction? Is there
an alternative period for which the Rule should restrict short sales
that persons intend to close-out by using shares acquired from the
issuer in PIPE transactions? What would be the impact on issuers
concerning short sales effected in connection with PIPE transactions if
the Rule applied to securities registered for resale in connection with
PIPEs transactions? For example, what would be the effect on issuers'
ability to attract PIPE investors and the effect on the market for the
issuers' securities?
Q. We are aware that short sales effected prior to the exercise of
conversion rights, such as those under a convertible debenture, can
depress stock prices and result in the issuance of more shares upon the
exercise of the conversion rights. For example, a convertible security
such as a convertible debenture may grant an investor the right to
convert all or a portion of the debenture into common stock based on a
formula using the price of the common stock at the time of conversion
with the investor receiving more shares on conversion if the market
price of the common stock declines. A person may be liable under the
anti-fraud provisions of the federal securities laws if that person
seeks to manipulate the stock price downward to enhance the economic
interests in a convertible security.\38\ Should Rule 105 address short
sales effected prior to the exercise of conversion rights?
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\38\ See, e.g., SEC v. Rhino Advisors, Inc. and Thomas Badian,
No. 03-CIV-1310 (SDNY 2003), Litigation Release No. 18003 (Feb. 27,
2003).
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Q. Should Rule 105 apply to issuances of rights to an issuer's
existing security holders to buy a proportional number of additional
securities at a given price (usually at a discount) within a fixed
period (a rights offering). Is there a similar potential for persons to
influence the offer price through a rights offering?
Q. Should the Rule address short sales effected in connection with
equity line financing arrangements in which an investor and a company
enter into a written agreement under which the company has the right to
put its securities to the investor in an offering in which the
securities are registered for sale or resale?
Q. Under the current and proposed rule, an investor with a long
position can legally sell all or part of the position during the five
days prior to the offer and still purchase shares in the offering. We
request comment on whether an investor with a long position may have
the same economic incentives to attempt this arbitrage or to manipulate
the price of the offer as a short seller. Aside from legal risk, are
the risks and returns of the long strategy any different from the risks
and returns of the short strategy? Can this strategy harm issuers?
Should the Commission consider broadening Rule 105 to include long
sales?
Q. Rule 200(a) defines the term ``short sale'' as any sale of a
security that the seller does not own or any sale that is consummated
by the delivery of a security borrowed by, or for the account of, the
seller. Should the Commission consider modifying this definition in
order to further the goals of this proposal?
Q. Should Rule 105 apply to offerings not made pursuant to a
registration statement on Form 1-A?
Q. Regulation E under the Securities Act of 1933 provides certain
small business investment companies and
[[Page 75007]]
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?
Q. Would this proposal be more effective than the existing rule in
deterring attempts to obscure violations of Rule 105 and limiting
manipulation of offering prices?
Q. Rule 200(c) of Regulation SHO states that, ``[a] person shall be
deemed to own securities only to the extent that he has a net long
position in such securities.'' In order to determine the net long
position, a seller of an equity security must aggregate all of that
person's positions in that security. Under Rule 200(f) of Regulation
SHO, however, a registered broker-dealer may qualify for independent
trading unit aggregation. We seek comment about the application of the
aggregation principles in the context of Rule 105 to non-broker-
dealers, including, for example, investment companies. Should non-
broker-dealers be provided an exception similar to that provided to
broker-dealers under Rule 200(f) of Regulation SHO based on these
aggregation principles, e.g., should there be a requirement that the
non-broker dealer be a registered investment adviser, or be a client of
a registered investment adviser for purposes of the excepted
transaction? If so, what criteria would be appropriate?
Q. Are there alternative approaches to revising Rule 105 that
should be considered?
Q. Beyond selling short, are there other types of trading
strategies that Rule 105 should address that similarly exert untoward
downward pressure on a stock's market price and thus lower market
prices prior to the pricing of follow-on and secondary offerings? How
should such trading strategies be addressed?
Q. Should potential investors in an offering be required to give an
underwriter a certification that they have not effected and will not
effect a short sale during the Rule 105 restricted period? What are the
costs and benefits of such a requirement for investors and
underwriters? Would this impact the costs of underwriting? Should any
such certification instead be provided to the broker-dealer through
which the person is purchasing the shares?
Q. We request comment on any liquidity or market efficiency impact
that the proposal may raise.
Q. Empirical evidence shows that, on average, issuers decline in
value by about 3% when they announce an impending public equity
offering. Later, issuers' value declines another 1% to 3% in the five
days prior to the offer. Following the offer, issuers' value recovers
but the value five days after the offer is still about \1/2\% lower
than the value five days before the offer.\39\ We request comment on
any effect the proposal will have on such price patterns, i.e., the
price of a security declining prior to an offering and not fully
recovering. Is this price pattern due to a type of evasion of Rule 105
that the proposed amendment would eliminate? Would these price patterns
change as a result of the proposal? Can the \1/2\% loss in issuers'
value be considered an economic benefit of the proposed amendment to
Rule 105? Can any of the 3% value decline at the announcement of a
public equity offer be considered an economic benefit of the proposed
amendment to Rule 105?
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\39\ Several empirical studies report these price patterns both
before and after the application of Rule 10b-21. See, e.g., Shane A.
Corwin, The Determinants of Underpricing for Seasoned Equity Offers,
58 J. Fin. 2249 (Oct. 2003).
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Q. We request comment on any impact the proposal may have on
trading and trading strategies.
Q. We request comment on any impact the proposal may have on
dynamic hedging activities.
Q. To what extent, if any, will the proposal increase or decrease
the potential for other types of manipulation?
Q. Are there any technical or operational challenges that would
arise in complying with the proposal?
Q. Does the proposal present any special compliance difficulties or
other issues?
Q. How much would the amendments affect specific compliance costs
or other costs for small, medium and large entities?
Q. We request comment concerning any effects that the proposal may
have on market participants, including underwriters as well as specific
effects that the proposal may have on the underwriting process.
Q. We request comment concerning any effects that the proposal may
have on issuers, including the ability of issuers to attract investors
to their securities offerings and the costs to issuers of completing
offerings.
Q. Would the proposed amendment create additional costs for or
otherwise impact short sellers, issuers, investors, underwriters, or
others?
Q. What are the economic costs or other costs associated with the
proposal?
General Request for Comments
The Commission seeks comment generally on all aspects of the
proposed amendment to Rule 105 of Regulation M. Any interested persons
wishing to submit written comments on the proposal, as well as other
matters that might have an impact on the proposal, are requested to do
so. Commenters are requested to provide empirical data to support their
views and arguments related to the proposal herein. In addition to the
questions posed above, commenters are welcome to offer their views on
any other matter raised by the proposed amendment to Rule 105. With
respect to any comments, we note that they are of the greatest
assistance to our rulemaking initiative if accompanied by supporting
data and analysis of the issues addressed in those comments and by
alternatives to our proposal where appropriate.
VI. Paperwork Reduction Act
We have not prepared a submission to the Office of Management and
Budget regarding the amendments to Rule 105 of Regulation M because the
proposals do not contain a collection of information requirement within
the meaning of the Paperwork Reduction Act of 1995.
VII. Consideration of Proposed Amendments to Rule 105 of Regulation M's
Costs and Benefits
The Commission is considering the costs and benefits of the
proposed amendments to Rule 105. The Commission is sensitive to costs
and benefits, requests data to quantify the costs and the value of the
benefits provided, and encourages commenters to discuss any additional
costs or benefits or reductions in costs beyond those discussed here.
Commenters should provide analysis and data to support their views on
the costs and benefits associated with the proposed amendment. If
applicable, the Commission requests comments on the potential costs for
any modification to computer systems and surveillance mechanisms as
well as any potential benefits resulting from the proposal for issuers,
investors, broker or dealers, other securities industry professionals,
regulators or other market participants.
A. Benefits
The proposal is intended to further safeguard the integrity of the
capital raising process and protect issuers from potentially
manipulative activity that can reduce issuers' offering proceeds. The
proposal also is designed to provide confidence to persons that they
are making investment decisions based on market prices and offering
prices unencumbered by artificial forces. Specifically, the proposal
would
[[Page 75008]]
prohibit a person who effects a short sale during the Rule 105
restricted period from purchasing, including entering into a contract
of sale for, the security in an offering. The benefits of the proposed
modifications to Rule 105 would be realized by many market
participants, including investors, issuers, selling security holders,
underwriters, short sellers and regulators.
The proposed amendments to Rule 105 are intended to further
facilitate market prices and offering prices that can be fairly
determined by the natural forces of supply and demand undistorted by
artificial forces. Currently, Rule 105 makes it unlawful for a person
to cover a short sale effected during the Rule's restricted period with
certain offering securities. The proposed amendment would eliminate the
covering component and instead prohibit a person who effects a short
sale during the Rule's restricted period from purchasing, including
entering into a contract of sale for, the security in an offering. The
proposal is intended to halt schemes designed to conceal the prohibited
covering. It also provides a bright line demarcation of prohibited
activity consistent with the prophylactic nature of Regulation M.
Issuers and selling security holders should benefit from the
proposal because it is designed to promote the goals of the current
rule, enhancing market integrity by precluding conduct that can be
manipulative around the time an offering is priced so that market
prices can be fairly determined by supply and demand. The proposal
should help issuers and selling security holders realize proceeds that
are not artificially low due to short selling. The proposal also would
promote investor confidence in the offering process, which should
foster capital formation. In turn, these benefits should encourage
issuers to conduct capital formation in the U.S. market.
Moreover, the proposed Rule 105 modifications retain much of the
flexibility of the current rule for traders because persons continue to
be able to sell short during the restricted period if they do not
purchase, including enter into a contract of sale for, the securities.
Persons also retain the ability to sell short prior to the Rule 105
restricted period and then purchase, including enter into a contract of
sale for, the securities.
We believe the proposed modification may reduce activity designed
to disguise rule violations. We believe this would lead to a reduction
in the number of instances of aggressive short sellers attempting to
place artificial downward pressure on market prices. Therefore, the
proposal would strengthen the ability of underwriters to set offering
prices without being encumbered by artificial activities in the market.
We believe short sellers would benefit from the proposal because it
provides a bright line test for Rule 105 compliance consistent with the
prophylactic nature of Regulation M. The proposal does not ban short
selling. Indeed, it would allow short sales that may contribute to
pricing efficiency and price discovery. The bright line demarcation is
important because it would provide clear guidance for short sellers
seeking to comply with Rule 105.
We believe the proposal may decrease the level of non-compliance
with the Rule. The proposed elimination of the Rule's covering
component should reduce attempts to disguise the covering activity
through convoluted trading structures. This would save significant
regulatory resources that would otherwise be spent pursuing evolving
strategies to disguise conduct that violates the Rule.
B. Costs
In complying with the proposed modifications to Rule 105, a person
that effects a short sale during a defined period could not purchase,
including enter into a contract of sale for, the security in the
offering. Under current Rule 105, persons that effect short sales
during a restricted period cannot cover their short position with the
offering securities. Thus, we believe any costs currently associated
with persons reviewing their restricted period short sales would remain
the same, as a person would use the current systems and surveillance
mechanisms for information gathering, management, and recordkeeping
systems or procedures. Indeed this proposal is intended to provide a
more straightforward means of compliance.
As an aid in evaluating costs and reductions in costs associated
with the proposed Rule 105 modifications, the Commission requests the
public's views and any supporting information. The Commission believes
that the proposed amendments would impose negligible costs, if any, on
traders and issuers and that the proposed amendments are appropriate
for the protection of investors and issuers and to promote the
integrity of the capital raising process.
The Commission staff has noted that investors desiring to
participate in hot issue offerings may improperly accommodate an
underwriter by participating in a cold issue. Investors may attempt to
protect themselves against losses in a cold issue by selling securities
short in the Rule 105 restricted period intending to cover with
offering securities in violation of Rule 105.\40\ We seek comment about
any impact the proposal may have on the underwriting process. If the
proposal impacts the underwriting process, would it make it easier or
more difficult for underwriters to sell offerings and what, if any,
impact would there be on efficiency of the pricing of an offering or
competition among underwriters?
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\40\ See supra n.11.
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The Commission encourages commenters to discuss all costs. In
particular, the Commission requests comment on the potential costs for
any modification to systems and surveillance mechanisms, and for
information gathering, management, and recordkeeping systems or
procedures. Commenters should provide analysis and data to support
their views on any costs associated with the proposed amendment.
VIII. Consideration of Burden on Competition and Promotion of
Efficiency, Competition, and Capital Formation
Section 3(f) of the Exchange Act requires the Commission, whenever
it engages in rulemaking that requires it to consider or determine if
an action is necessary or appropriate in the public interest, to
consider whether the action would promote efficiency, competition, and
capital formation.\41\ In addition, Section 23(a)(2) of the Exchange
Act requires the Commission, in adopting rules under the Exchange Act,
to consider the anti-competitive effects of any rules it adopts.\42\
Exchange Act Section 23(a)(2) prohibits the Commission from adopting
any rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act.
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\41\ 15 U.S.C. 78c(f).
\42\ 15 U.S.C. 78w(a)(2).
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The Commission preliminarily believes that the proposed amendment
would promote capital formation through improved integrity of the U.S.
securities markets by precluding conduct that can depress security
prices during a critical period of time in the capital raising process.
Preventing the type of potentially manipulative activity targeted by
the proposed amendment would help protect the pricing process so that
the forces of supply and demand are not undermined. The proposal would
promote price determinations and movements that result from natural
market forces, undistorted by artificial influences. We request comment
on the
[[Page 75009]]
impact of the amendment on capital formation.
Short sales based upon a person's evaluation of the issuer's
fundamentals (products, earnings, management, etc.) and a security's
future performance may contribute to pricing efficiency and price
discovery. Such short sales reflect the value that a trader assigns to
an issuer's security. However, short sales prior to pricing an offering
by a person who expects an offering allocation and anticipates making a
quick profit from effecting the short sale and then purchasing,
including entering into a contract of sale for, the security in the
offering, may not similarly reflect the trader's evaluation of the
issuer's fundamental value.
The Commission staff has noted that investors desiring to
participate in hot issue offerings may improperly accommodate an
underwriter by participating in a cold issue. Investors may attempt to
protect themselves against losses in a cold issue by selling securities
short in the Rule 105 restricted period intending to cover with
offering securities in violation of Rule 105.\43\ We seek comment about
any impact the proposal may have on the underwriting process. If the
proposal impacts the underwriting process, would it make it easier or
more difficult for underwriters to sell offerings and what, if any,
impact would there be on efficiency of the pricing of an offering or
competition among underwriters?
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\43\ See supra n.11.
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The Commission has considered the proposal in light of the
standards cited in Section 23(a)(2) and believes preliminarily that, if
adopted, the proposed amendments would not impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act. Specifically, the proposed version of the Rule
would continue to allow short sales based on a person's view of a
security's future performance. Traders could sell short before the
restricted period. Alternatively, traders could sell short during the
restricted period if they do not purchase, including enter into a
contract of sale for, the securities. The proposal would provide a
bright line approach designed to prevent improper conduct and to
provide a bright line demarcation regarding conduct that is prohibited
for persons wishing to comply with the rule.
The Commission generally requests comment on the competitive or
anticompetitive effects of the proposed amendments to Rule 105. The
Commission also requests comment on what impact the proposed amendments
to Rule 105 would have on efficiency and capital formation. Commenters
should provide analysis and empirical data to support their views on
the costs and benefits associated with the proposal.
IX. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or (SBREFA),\44\ we must advise the Office of Management
and Budget as to whether the proposed amendments constitute a ``major''
rule. Under SBREFA, a rule is considered ``major'' where, if adopted,
it results or is likely to result in:
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\44\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified
in various sections of 5 U.S.C. and as a note to 5 U.S.C. 601).
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An annual effect on the economy of $100 million or more
(either in the form of an increase or a decrease);
A major increase in costs or prices for consumers or
individual industries; or
Significant adverse effect on competition, investment, or
innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review. We request comment on the
potential impact of the proposed amendments on the economy on an annual
basis. Commenters are requested to provide empirical data and other
factual support for their view to the extent possible.
X. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (IRFA), in accordance with the provisions of the Regulatory
Flexibility Act (RFA) \45\ regarding the proposed amendment to Rule 105
of Regulation M.
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\45\ 5 U.S.C. 603.
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