SEC Fines 23 Firms for Illegal Short Selling – Lessons for All Investment Firms

“In announcing the enforcement actions, Andrew J. Ceresney, Co-Director of the SEC’s Division of Enforcement, emphasized that the Staff has ‘zero tolerance for any securities violations, including violations that do not require manipulative intent.’” (BakerHostetler)

In mid-September, the Securities and Exchange Commission charged 23 investment firms with violating an SEC rule that prohibits firms from short selling a stock during the restricted period ahead of a public offering, only to buy back the same shares through the offering.

According to the agency, the firms violated Rule 105 of Regulation M of the Securities Exchange Act when they “bought offered shares from an underwriter, broker, or dealer participating in a follow-on public offering” after selling the same securities during the restricted period. 22 of the firms will pay a total of $4.4 million in fines for the violations (one is fighting the charges).

What lessons can all investment firms draw from the crackdown?

1. The SEC doesn’t care whether or not you made money on the deal:

“[T]here seems to be no materiality threshold for the SEC to bring enforcement actions regarding Rule 105, as actions have been brought for violations resulting in total profits as small as $4,091. These settlements, therefore, send a strong signal to the market that Rule 105 will be scrupulously enforced for even minor violations.” (Ropes & Gray)

2. Violating Rule 105 is illegal regardless of your intentions:

“Rule 105 applies to all short selling activities in violation of the rule regardless of intent. […] Intentional violations aside, there are a handful of ways that an investment firm might potentially violate Rule 105, including ‘compliance breaks,’ a ‘plow through’ and a ‘short selling restriction failure.’” (Pepper Hamilton)

3. Your compliance program must comply with Rule 105:

“Investment advisers, broker-dealers and other financial firms would be well advised to review and update their compliance programs to ensure that they are compliant with Rule 105’s requirements. This is particularly advisable for investment advisers that operate multiple funds and/or strategies.” (BakerHostetler)

4. There are limited exceptions to the rules:

“The three exceptions to Rule 105 are: (a) the ‘bona fide purchase’ exception that generally permits persons to purchase securities in the offering even if they sell short during the Rule 105 restricted period, […] (b) the ‘separate account’ exception that generally allows a purchase of the offered securities in an account that is related to or affiliated with the account that made the short sale, […] and (c) the ‘investment company’ exception that allows a registered fund to participate in an offering…” (Morrison & Foerster)

5. You can get credit for playing nice:

“[T]he consent orders demonstrate the SEC’s continued implementation of its Cooperation Initiative. According to the consents, all but one of settling respondents received credit for their ‘prompt’ remedial efforts and cooperation with the SEC Staff. Tellingly, the consent order against the non-cooperating respondents is the only one of the orders that included sanctions against an individual — the sole owner, principal and officer of the co-respondent firms.” (BakerHostetler)

The updates:

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