Short Selling in Connection With a Public Offering, 75002-75011 [E6-21141]

Download as PDF 75002 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 (http://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 (http://www.regulations.gov). Follow the instructions for submitting comments. rwilkins on PROD1PC63 with PROPOSAL_2 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 (http://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; VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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’’). PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 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 E:\FR\FM\13DEP2.SGM 13DEP2 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 rwilkins on PROD1PC63 with PROPOSAL_2 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. VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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 PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 75003 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. E:\FR\FM\13DEP2.SGM 13DEP2 75004 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules rwilkins on PROD1PC63 with PROPOSAL_2 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. VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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. PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 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. E:\FR\FM\13DEP2.SGM 13DEP2 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules 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 rwilkins on PROD1PC63 with PROPOSAL_2 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. VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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). PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 75005 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. E:\FR\FM\13DEP2.SGM 13DEP2 75006 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules rwilkins on PROD1PC63 with PROPOSAL_2 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. VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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 PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 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). E:\FR\FM\13DEP2.SGM 13DEP2 rwilkins on PROD1PC63 with PROPOSAL_2 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules 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 VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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). PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 75007 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 E:\FR\FM\13DEP2.SGM 13DEP2 rwilkins on PROD1PC63 with PROPOSAL_2 75008 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules 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 VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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 PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 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 E:\FR\FM\13DEP2.SGM 13DEP2 rwilkins on PROD1PC63 with PROPOSAL_2 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules 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. VerDate Aug<31>2005 20:10 Dec 12, 2006 Jkt 211001 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 Frm 00009 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 E:\FR\FM\13DEP2.SGM 13DEP2 75010 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules rwilkins on PROD1PC63 with PROPOSAL_2 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 VerDate Aug<31>2005 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 Sfmt 4702 E:\FR\FM\13DEP2.SGM 13DEP2 Federal Register / Vol. 71, No. 239 / Wednesday, December 13, 2006 / Proposed Rules 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 Frm 00011 Fmt 4701 Sfmt 4702 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 E:\FR\FM\13DEP2.SGM 13DEP2

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 (http://
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 (http://
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 (http://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.
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    \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.
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    \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).
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    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\
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    \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.).
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    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.
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    \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.
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    \33\ Reg. M Adopting Release, 62 FR at 538.
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    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\
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    \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?
---------------------------------------------------------------------------

    \40\ See supra n.11.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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?
---------------------------------------------------------------------------

    \43\ See supra n.11.
---------------------------------------------------------------------------

    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:
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

     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.
----------------------