On September 16, 2014, the Securities and Exchange Commission (“SEC”) announced that it charged 19 firms and an individual trader with violations of Rule 105 of Regulation M under the Securities Exchange Act of 1934 (“Rule 105”). This round of sanctions follows the largest Rule 105 sanction ($7.2 million) announced in March of this year and a round of 23 sanctions announced in September 2013.
The sanctions for this latest round generally included cease and desist orders, disgorgement of profits plus prejudgment interest, and fines.
Notably, there seems to be no materiality threshold for the SEC to bring Rule 105 enforcement actions, as the recent sanctions were levied for violations resulting in total profits as small as $21,844, and previous sanctions were levied for violations resulting in total profits as small as $4,091. As such, it is clear that the SEC is sending a strong signal to the market that Rule 105 will be strictly enforced for even minor violations. This continuing enforcement initiative is a reminder that hedge fund managers should review and/or enhance their compliance efforts with respect to Rule 105.
Subject to certain limited exceptions, Rule 105 generally prohibits purchasing equity securities in a public offering of such securities if one has made a short sale of the same security during the shorter of (i) the period beginning five business days prior to the pricing of the offering and ending with the pricing, and (ii) the period beginning with the initial filing of the registration statement (or equivalent form) and ending with the pricing.
Rule 105 is prophylactic and prohibits the conduct irrespective of the short seller’s intent in effecting the short sale or whether the short seller suffered a loss on the transactions.
The SEC’s latest sanctions bring the total Rule 105 actions to 43 amounting to over $30 million in disgorgement, interest, and penalties in less than one year and reflects the SEC’s continued focus on Rule 105 violations. The mechanical nature of the sanction orders highlight that a Rule 105 enforcement proceeding is an easy case for the SEC to bring particularly in light of the fact that there is no requirement of intent to violate Rule 105, and violations are often very clear.
Once the SEC successfully enforces a Rule 105 violation, any SEC registered investment adviser must report such disciplinary event for 10 years on its Form ADV, and a hedge fund manager would likely need to disclose such Rule 105 violation in any offering memoranda for funds that it manages. It is also important to note that after-the-fact remediation does not absolve a firm or individual from the violation of Rule 105, although it may be taken into account by the SEC in determining to accept a settlement offer.
Accordingly, it is imperative that hedge fund managers proactively review their policies and procedures related to short selling and public equity offerings and take all necessary steps to protect against future violations of Rule 105.