SEC adopts amendments to Rule 105 of Reg M

By Cydney Posner

The SEC has adopted amendments to Rule 105 of Reg M designed to protect issuers from manipulative activity that can reduce issuers' offering proceeds and dilute shareholder value. The new rule becomes effective on October 9, 2007.

The former Rule 105 prohibited covering short sales effected during a defined restricted period with securities purchased in an offering. Under that rule, the prohibited activity was "covering." However, there has been substantial non-compliance and a proliferation of trading strategies and structures attempting to accomplish the economic equivalent of the activity that the rule sought to prevent. To address that problem, the new rules eliminate the covering requirement and change the prohibited activity from "covering" to "purchasing" the offered security.

The proposed amendments would have made it unlawful for a person to effect a short sale during the Rule 105 restricted period and then purchase the security in a subsequent offering, in effect, imposing an absolute prohibition against purchasing offered securities in firm commitment offerings by any person that effected a restricted period short sale. However, in response to comments, as adopted, amended Rule 105 refines the proposed amendment by adding several new exceptions.

Bona Fide Purchase Exception

The new amendments add a "bona fide purchase provision" that allows restricted period short sellers to participate in offerings if they make "bona fide" purchases that close out the short, i.e., if they make a purchase equivalent in quantity to the amount of the restricted period short sale, prior to pricing of the offering. The rule requires that the purchase be bona fide, which will necessarily depend on the facts and circumstances. The SEC emphasizes, however, that any transaction that, while made in technical compliance with the exception, is part of a plan or scheme to evade the rule (for example, a transaction that does not include the economic elements of risk associated with a purchase for value), would not be bona fide for purposes of amended Rule 105. The purchase must be at least equivalent in quantity to the entire amount of the Rule 105 restricted period short sale; partial purchases are insufficient. The provision also requires that the person effect the bona fide purchase during regular trading hours and, to ensure transparency of the activity to the market, that the bona fide purchase be reported pursuant to an effective transaction reporting plan. The bona fide purchase must be made after the last Rule 105 restricted period short sale and no later than the business day prior to the day of pricing. In addition, a person relying on this provision may not effect a Rule 105 restricted period short sale within the 30 minutes before the close of regular trading hours on the business day prior to the day of pricing.

Separate Accounts and Investment Company Exceptions

The amended rule also includes a new exception that applies to Rule 105 the principles in Reg SHO for independent trading unit aggregation for separate accounts, which allow a person to purchase the offered securities in an account, even if there was a short sale in another account, so long as decisions regarding securities transactions for each account are made separately and without any coordination of trading or cooperation among or between the accounts. The new rule sets forth the indicia for determining whether accounts are "separate," including requirements that there be no communication of securities positions, investment decisions or other trading matters between accounts and that the accounts maintain separate profit and loss statements.

In light of provisions of the Investment Company Act that generally prohibit concerted action between funds in a fund complex and between different series of the same fund, the SEC has also adopted an exception related to registered investment companies. Under this exception, an individual fund within a fund complex, or a series of a fund, will not be prohibited from purchasing the offered security if another fund within the same complex or a different series of the fund sold short during the Rule 105 restricted period.

Additional Amendments

There are several other new amendments, including amendments that refine the scope of the rule by restricting its application to offerings of "equity" securities for cash, include offerings under Reg A and Reg E under Rule 105, define "subject security" as the security that is the "subject" of the offering (with the result that purchases in an offering of convertible securities following short sales of the underlying common equity would not violate Rule 105) and retain the requirement of the former rule that the purchase of the offered security be made "from an underwriter or broker or dealer participating in the offering,"

The release also notes that the SEC will continue to monitor the use of derivative strategies that may replicate the economic effect of the activity that Rule 105 is intended to prevent.

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