Two California investment advisory firms, separately and recently charged by the Securities and Exchange Commission (SEC) with engaging in improper short selling of securities in advance of their participation in a company’s secondary offering, have arrived at a settlement with the SEC. (i) In settling these actions, the SEC, for the first time, enforced its amended Rule 105 of Regulation M, which is designed to prohibit manipulative short selling ahead of follow-on securities offerings.

More recently, on Feb.24, the SEC voted to limit short selling of stocks that are falling rapidly in price. The limits would apply to any stock whose price has fallen at least 10% during a day’s session. After that, short selling would still be legal but not unless the sale was at a price higher than the best bid price then available.

With these two recent developments, the SEC will likely continue to fight violations of Rule 105. There is speculation this will be a prelude to even more stringent enforcement activities. In light of this increased scrutiny and the indication that the SEC is going to police what it views as “manipulative activities” in the financial markets, it is more important than ever to have a clear understanding of the applicable laws and of the dos and don’ts of short selling.

Amended Rule 105 of Regulation M

In an effort to “protect the independent pricing mechanism of the securities market” and deter “short selling that can artificially depress market prices which can lead to lower than anticipated offering prices,” (ii) the SEC promulgated Rule 105 of Regulation M. As amended, Rule 105 prohibits purchasing securities as part of an “offering” if that security was also shorted within the five days immediately preceding the “pricing” (or within the period between the registration statement and the pricing, whichever is shorter). To trigger a violation of Rule 105, two events must take place:

(1) The short sale of a stock within the five (5) days before it is priced (the “restricted period”) for an initial or secondary offering; and

(2) The purchase of that stock from an underwriter or broker or dealer participating in the offering.

All that is required to trigger a violation of Rule 105, therefore, are a short sale during the restricted period and a purchase made as part of an offering. The SEC indicated that the 2007 amendment was prompted by short sellers’ efforts to evade the existing prohibitions. The same rationale was invoked by the SEC in justifying its most recent vote to limit the short selling of stocks whose prices are falling rapidly.

Separate Accounts Not Necessarily Enough

In one of the two separate, but related, actions in which the SEC enforced amended Rule 105 of Regulation M for the first time, the SEC charged Los Angeles-based AGB Partners LLC and its principals with netting thousands of dollars by shorting in advance of their purchase of stock in a secondary offering. In the other case, the SEC charged Los Angeles-based Palmyra Capital Advisors LLC with violating short selling rules and improperly profiting in three of its managed hedge funds.(iii)

Interestingly, in the AGB case, the short sale occurred in connection with the AGB account, but the purchase in the follow-on offering was effected in a separate account under a different name. The accounts were held at two different prime brokers, had separate trading strategies, and maintained separate profit and loss statements. Nevertheless, the SEC alleged that AGB did not manage the accounts separately; and, according to the SEC, there were no information barriers to separate the accounts or to prevent information sharing about securities positions and investment decisions. AGB’s principals allegedly shared trading ideas often, according to the SEC’s complaint. As a result, the SEC asserted that AGB and its principals violated Rule 105.

Implications of SEC’s Actions

These actions, as well as the SEC’s most recent vote to limit short selling, herald a critical time for managers and their hedge funds to be vigilant about ensuring that their complianceis up to par. Penalties imposed on market participants who commit short selling violations are likely to be significant.

What exactly, therefore, should managers and hedge funds do?

First, market participants who engage in short selling and participate in follow-on offerings of equity securities would be wise to engage experienced outside counsel to review their firm’s compliance policies and procedures in connection with Rule 105. In light of the case against AGB in particular, firms must give careful consideration to determine whether transactions undertaken in connection with separate accounts or entities should nevertheless be aggregated for purposes of Rule 105 compliance.

Second, and perhaps most importantly, once outside counsel completes the review of the firm's written compliance policies and procedures, and has met with fund managers, outside counsel should sit with fund employees for a detailed discussion of short selling laws, address real-life possible scenarios employees and managers should avoid, and answer questions from employees and managers.

Doing all of this will go a long way in emphasizing the importance of compliance and help ensure that everyone—managers and employees alike—understand the law and how to avoid potential pitfalls.

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DLA Piper is a leader in securities litigation defense. By providing experienced legal counsel for individuals and entities that are involved in securities litigation, DLA Piper’s successful counseling of clients and handling of these types of cases has resulted in over 50 reported decisions since the passage of the Private Securities Litigation Act of 1995 (PSLRA). DLA Piper represents private equity funds including hedge funds, broker-dealers, placement agents and issuers (including their officers and directors) in SEC and FINRA enforcement proceedings, white collar criminal proceedings and individual and class action securities fraud and related claims.

Perrie Michael Weiner is the International Co-Chair of DLA Piper's securities litigation practice and a managing partner of the Century City office. He may be reached at (310) 595-3024. www.dlapiper.com.

i Short selling typically involves locating and borrowing a company’s shares, selling them, buying them back at a later date (and, hopefully, at a lower price) and returning them to the lender to close out the short position. A short seller, if the stock price falls, realizes a profit from the difference between the sale and purchase price in a declining market. Short selling has a long history and is a legitimate and, with a few exceptions, lawful trading strategy.

ii Securities Exchange Act Release No. 34-56206 (August 6, 2007).

iii In settling the SEC’s charges without admitting or denying the SEC’s allegations, AGB and its principals purportedly consented to be censured and agreed to pay more than $50,000 in disgorgement and penalties. Palmyra Capital also purportedly consented to be censured and to pay more than $330,000 in disgorgement and penalties.

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