More on Illegal Short Sales

By: Cydney Posner

In yet another action regarding illegal short sale activity, the SEC today announced the entry of final orders in actions brought against three hedge fund advisers for violations of Rule 105 of Reg M in connection with follow-on offerings.

See: Press Release and Administrative Proceedings for DB Investment Managers, Inc., Galleon Management, L.P., and Oaktree Capital Management, LLC.

Short sales can adversely affect an issuer's share price, reducing proceeds of a follow-on offering to the issuer and injuring existing investors.

Rule 105, an anti-manipulation rule, prohibits covering a short sale with securities obtained in a follow-on offering if the short sale occurred within five business days before the pricing of that offering. The rule is designed to prevent persons from improperly profiting by selling short with the expectation that they will cover that short position with lower priced shares obtained from the offering. In recent interpretive guidance, the SEC has said that "where the transaction is structured such that 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, that transaction may be a sham transaction."

The SEC charged that the hedge funds had violated Reg M in connection with 22 follow-on offerings of seasoned issuers. The SEC contended that two of the hedge funds engaged in "sham" transactions in which they created large short positions within the Rule 105 restricted period, purchased shares in a follow-on offering and then engaged in further transactions or trading practices to make it appear that the trading complied with Rule 105, when in fact it did not.

The SEC contended that one of the funds violated Red M in connection with 17 offerings. This fund was alleged to have routinely created "boxed" positions by establishing a long position with shares purchased in a follow-on offering while simultaneously maintaining a corresponding short position, established during the restricted period, in the securities of the same issuer. In some instances, the SEC alleged, the fund then instructed its prime broker to "collapse the box" through the use of offsetting journal entries that canceled out the long and short positions. The SEC also alleged that, from time to time, the fund unwound its boxed positions by contemporaneously entering a market order to sell the offering shares and another order to purchase an equivalent number of shares, which were then used to cover the short position that had been established during the Rule 105 restricted period. These unwinding transactions were entered through two different brokers and executed in the open market, with little risk to the fund. In the case of another fund, on the pricing date for each offering, but prior to any sale transactions in the relevant securities, the fund submitted a tiered indication of interest to the lead underwriter of the follow-on offering. The fund then sold short shares of the issuer in amounts that represented a portion of its anticipated allocation in the deal. With no open stock position in the issuer at the time of this transaction, however, the order was improperly marked as a long sale, but should have been marked short. The other fund "flattened" a follow-on offering boxed position by executing a cross trade, in which it crossed the long and short position against each other, resulting in a flat position in the issuer’s stock. According to the SEC, this cross trade served no legitimate economic purpose and involved no real market risk.

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