NEW YORK (Thomson Reuters Regulatory Intelligence) - U.S. securities regulators on the lookout for manipulative trading violations have gotten very good at uncovering them, and firms must be on their guard to prevent infractions. This was evident last week when the U.S. Securities and Exchange Commission (SEC) settled a case that involved short-selling in stocks of companies planning follow-on secondary offerings and then illegally purchasing shares in the offerings.
The SEC announced on October 31(here it had settled an enforcement action involving hedge fund giant Millennium Management LLC. The enforcement was related to alleged violations of Rule 105 short-selling restrictions that occurred in 2012. In announcing the settlement, the SEC's New York regional office said, "We will continue to actively surveil for, and charge, violations of Rule 105 where appropriate."
Below is a review of Rule 105 violations and the SEC’s continued emphasis on the rule in light of the Millennium case. This article also offers some compliance best practices and suggestions related to the rule.
Rule 105 of Regulation M(here is an anti-fraud provision contained in Regulation M under Section 10(b) of the Securities Exchange Act of 1934(here The rule aims to restrict trading activity that would weigh on an issuer's stock price and cause a company to receive less from an offering than normal market conditions would dictate.
The rule prohibits purchasing securities in follow-on and secondary offerings when the purchaser has effected a short sale in the same security. The time window covered by the rule is the lesser of either five trading days, or, less commonly, the number of days from the initial filing of the registration statement to the pricing of the offering.
The rule only applies to underwritten offerings of equity securities that are SEC-registered. It does not apply to offerings exempt from registration, that is, Reg D(here, Rule 144A(here, registered direct, or PIPE offerings which often carry their own specific trading prohibitions that are unique to each particular offering. Exceptions may also apply with international offerings.
A Rule 105 violation does not require intent by the short seller to engage in a prohibited transaction. The violation occurs when the short sale is effected in the restricted five-day window and then the investor purchases shares of the same security in the offering. If for any reason a short sale is effected that is subject of an offering, the investor must simply refrain from purchasing shares in the offering or rely on an exception in order to comply with the rule. A short sale alone in the security during the window is not a violation.
There are a few exceptions to the rule that would allow a short seller to participate in an offering during the restricted period. They are bona fide purchases and separate account purchases detailed below:
— Investors can purchase an amount of shares equivalent at least to the entire amount of the restricted short sales. The purchases must occur after the investor’s last restricted short sale, during normal trading hours, and no later than the business day prior to pricing of the offering.
— Separate account managers can participate for accounts other than an account that has sold short during the restricted period. There must be true separation of the accounts. Advisers will need to be prepared to show that the accounts have: separate investment and trading strategies and objectives, separate personnel that do not coordinate trading, information barriers between accounts, separate profit and loss statements for each account, and no allocation of securities between the accounts.
According to the Millennium Management LLC website(www.mlp.com/home/), the firm was founded in 1989 and manages approximately $35 billion in assets, with more than 2,300 employees working in the United States, Europe and Asia. It is widely known as one of the oldest and largest hedge funds, with a long record of success. The firm gives its primary focus as "generating high-quality returns by engaging and overseeing a large number of specialized trading teams, each of which pursues specific strategies."
Large numbers of traders or trading teams can be challenging environments for avoiding Rule 105 violations; it can be difficult to monitor numerous market participants in different locations with independent strategies.
According to the SEC's settlement with Millennium(here, the firm employed a large number of portfolio managers (PMs) to manage the Master Fund's investments, and many regularly participated in secondary stock offerings. Millennium also maintained several accounts for risk management and hedging (firm accounts) related to the Master Fund portfolio. Although each portfolio manager trading group only had access to information in their own particular group, and separate profit and loss calculations and compensation were maintained for each group, management personnel who established the firm accounts for risk and hedging were not similarly segregated.
Management personnel of the risk and hedging accounts “had the ability to review each PM group’s portfolio holdings and trading activity through Millennium’s proprietary order entry and portfolio-management system, and also had the authority to set the trading strategies that were executed in the firm accounts,” the SEC said. As a result, the firm accounts did not qualify for the Rule 105 separate-accounts exception. Therefore, if any of the firm accounts sold short a security during the Rule 105 restricted period, the rule prohibited any PM group from purchasing in the secondary offering of that security.
The settled complaint alleged four securities trades in 2012 where the firm accounts sold short fewer than 10,000 shares — small transactions for a fund the size of Millennium — which restricted their ability to participate in the secondary offerings.
The SEC’s capability to detect these few violations in small trades by a firm the size of Millennium, which undoubtedly trades millions of shares daily, is noteworthy. The SEC’s detection of these trades and putting all the pieces together is akin to finding needles in an enormous haystack, but the agency has widely publicized its expanded capabilities using modern data analytical tools.
Millennium agreed to stop violating Rule 105 without admitting or denying the SEC’s findings. As part of the settlement, the SEC ordered the firm to pay a total of $638,709, including $286,889 in disgorgement, $51,820 of interest and a $300,000 penalty.
“It’s very hard for large firms to meet the SEC separate-account exception,” said attorney Jack Yoskowitz of Seward & Kissel LLP, who has represented several firms charged with Rule 105 violations. Yoskowitz did not represent Millennium in this case.
The Millennium case came two years after the SEC announced enforcement actions against six firms(here for short-selling violations in advance of share offerings. The SEC has made enforcements of Rule 105 an annual occurrence since 2013, the same year it issued a risk alert on the topic(here).
Some advisers have taken note and put safeguards in place, and the number of violations appears to be shrinking each year since the risk alert. Nevertheless, some advisers continue to get tripped up by the rule.
The consequences of violating the rule can be costly. Settled administrative proceedings have included a cease-and-desist order, profit disgorgement, civil fines, interest, and public disclosure. The profit disgorgement is often the largest monetary component; as the method of calculation has two components.
The first calculation is the profit on the short sale, which is the difference between the per-share price received in the short sale and the per-share price paid in the offering. The second calculation is the improper benefit the manager obtained with respect to the participation in the offering in excess of the number of the shares sold short. This is calculated by multiplying the difference of the closing price before the offering and the price of the offering.
In many of the cases the disgorgement of the profit from the secondary offering far exceeded the profit on the short sale. In a JPMorgan Investment Management settlement(here, some violations were triggered by short sales of fewer than 1,000 share trades that wiped away the profits of significantly larger allocations in the offerings. In one instance a short sale of 7,000 shares and a short profit of only $11,521 caused the disgorgement of $194,848 on a secondary offering purchase of 440,535 shares. The math on the Millennium trades was similar: small short sales yielded minor gains at best that negated all of the profit on the secondary purchase.
In every instance the SEC also tacked on a civil fine and interest calculation from the time of the infraction to the time of the settlement. All of these add up to be a significant cost for a careless trading misstep.
THE ONLY SUCCESSFUL COURT VICTORY BY A FIRM IN DEFENSE OF A RULE 105 CHARGE
Since launching its Rule 105 sweeps in 2013, the SEC has brought dozens of enforcement actions for purported violations of the rule. The vast majority have settled. Very few have chosen to challenge Rule 105 claims in federal court. One such case, brought by the SEC in January 2014, was recently dismissed in the Southern District of New York.
The case was SEC v. Revelation Capital Management(here Revelation, represented by Yoskowitz, argued that the secondary offering was not conducted on a firm commitment basis and was therefore excepted under Rule 105(c). Revelation also argued that Rule 105 lacks extraterritorial reach, and the participation in the offering was not sufficiently "domestic" to warrant application of the rule. They detailed the foreign nature of the offering, from the foreign defendants’ negotiation with the Canadian underwriter for the purchase of shares, to the deposit of the share certificate with the Canadian Depository for Securities, to the wiring of offering proceeds to the issuer in Canada.
The court rejected the SEC’s argument that the prior short sales of shares listed on the New York Stock Exchange meant the rule applied(here). Rather, the court found that the "primary focus" of Rule 105 is "the purchase of offering shares," which in this instance occurred in Canada therefore, the offering was "entirely foreign."
Advisers are reminded that, in order to comply with Rule 105, it is important to train their employees on it. They must develop, implement and enforce policies and procedures to comply with the rule. The suggestions below should be considered by all advisers whose trading activity puts them at risk of violating the rule.
— Advisers must train and inform all investment professionals of the rule.
— Update existing written policies and procedures to include Rule 105 language.
— Create and test a strategy to detect violations as they occur so they can be immediately be remediated.
— Require trading desks or a designated head trader to check a master trade blotter for triggering trades before putting in orders on secondary offerings.
— Require portfolio managers or traders to follow the written procedures related to secondary offerings.
“Large firms have to be especially careful that policies and procedures require a complete sweep of the entire firm’s trading activities before participating in any offering,” Yoskowitz said.
Investment advisers should educate and train trading and portfolio management personnel on Rule 105. Most importantly, it is essential to have a policy and safeguard such as code written into an order management system that requires a point person such as a head trader to check a firm-wide trade history before entering any order in a secondary or follow-on offering. This simple check would likely keep all advisers from violating the rule and having to deal with the costly headache of an SEC enforcement action.
(By Todd Ehret of Regulatory Intelligence in New York. Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence.)
This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Nov. 7. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters