On September 16 and 17, 2013, the U.S. Securities and Exchange Commission announced 22 settled cases and one litigated case involving violations of Rule 105 of Regulation M. This brings to over 40 the number of Rule 105 cases brought by the Commission in the past three and a half years. In addition, the SEC’s Office of Compliance Inspections and Examinations issued a risk alert regarding Rule 105 (the “Risk Alert”), in the wake of the announcement of the cases, discussing the basis for the alleged violations and assessed penalties, and suggesting best practices to avoid violations of Rule 105.1
Rule 105 “makes it unlawful for person to purchase equity securities from an underwriter, broker, or dealer participating in a public offering if that person sold short the security that is the subject of the offering during the [applicable] restricted period, absent an exception.”2 Rule 105 only applies to firm commitment offerings3 and includes exceptions for certain “bona fide” purchases, purchases in separate accounts, and purchases by investment companies, as long as certain conditions are met. Rule 105 can be violated without specific intent to violate the rule. To emphasize this point, in the Risk Alert, OCIE stated that “Rule 105 does not require intent on the part of the short seller to engage in a prohibited transaction; one violates the rule if such person sells short the security that is the subject of the offering during the restricted period (and does not fit into one of the Rule’s three exceptions) and then purchases shares of that security in the offering.”4
Registered and unregistered (including non-US) investment advisers made up the vast majority of parties charged in the settled and litigated Rule 105 enforcement actions to date. Broker-dealers also were charged. In these enforcement actions, the Commission alleged that firms violated Rule 105 by receiving shares in firm commitment underwritten offerings after selling short during the Rule 105 restricted period. The settled cases generally have required parties to pay disgorgement, prejudgment interest and a civil penalty.
In the Risk Alert, OCIE noted that the “enforcement actions have specified, and . . . examinations have observed, deficient practices relating to Rule 105.”5
OCIE reminded firms of the importance of:
OCIE pointed out that in assessing the applicable penalties for the Rule 105 enforcement actions, the Commission took into account specific remedial efforts, such as “developing and implementing policies, procedures and controls to prevent or detect Rule 105 violations in determining the appropriate resolution.” The staff further pointed out, however, that had “these same remedial steps…been proactively implemented, [they] may have prevented the violations.”6 And, as noted above, OCIE also pointed out that they have identified “deficient” practices as well as inadequate policies and procedures in their examinations of registered investment advisers.7
Clearly the SEC and its staff are focusing on Rule 105 compliance, and appear to be applying a strict standard in evaluating whether violations have occurred. Therefore, firms, and in particular broker-dealers and investment advisers, should review their Rule 105 policies and procedures to ensure that they are sufficiently “robust” and also consider establishing periodic Rule 105 training programs so that firm employees have a clear understanding of the rule, what is expected of them and how they can avoid violating the rule. Bingham regularly advises clients, including but not limited to, asset managers and broker-dealers, on all aspects of regulation and frequently advises on the robustness of Rule 105 policies and procedures and training programs, in addition to providing “real time” counsel on Rule 105 compliance in specific situations and with regard to contemplated transactions.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Kroll-Amy
This article was originally published by Bingham McCutchen LLP.