Amnds RegM105 2

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From PLI’s Course Handbook
Hedge Fund Enforcement & Regulatory Developments 2007
#13696

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RECENT AMENDMENTS TO REGULATION
M, RULE 105—OVERVIEW

Guy M. Miller
Goldman, Sachs & Co.

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Guy M. Miller
Vice President and Associate General Counsel
Goldman, Sachs & Co.

September 2007

Recent Amendments to Regulation M, Rule 105 – An Overview

1. Revised Rule 105:
a. Generally prohibits any person who has effected one or more short sales in a “subject security”
during the applicable “Rule 105 restricted period” from purchasing in a public offering of
“offered securities”.
i. Subject to certain exceptions. (See Section 3 below.)

b. Defined Terms:
i. “Offered Securities”: Equity securities offered for cash pursuant to a registration
statement or notification (Forms 1-A or 1-E) filed under the Securities Act of 1933.
1. Definition explicitly limited to equity offerings; Rule 105 previously was silent
on this point.
2. Applies to securities offered pursuant to Regulations A and E under the
Securities Act.
3. No exception for “actively-traded securities” (as defined in Regulation M,
Rule 100).
a. SEC found that many perceived violations of previous Rule 105
occurred in such securities.
ii. “Subject Securities”: Defined as “…the security that is the subject of the offering…”.
1. Adopting Release references Regulation M Rule 100 definition of “covered
security”, which includes, as a component of its definition, “subject
securities”.
2. Definition is limited to the offered securities themselves.
a. Unlike Rule 100 definition of covered security, definition of subject
securities does not include “reference securities” (defined in Rule
100 as any security into which a subject security may be converted,
exchanged or exercised or which may, in whole or part, determine
the value of the subject security).
b. Thus, in offering of convertible securities, underlying common
equity is not considered a “subject security” for purposes of Rule
105. (The common equity would continue to be considered a
“reference security” and, thus, a “covered security” subject to the
general provisions of Regulation M (Rules 101 and 102)).
iii. “Rule 105 Restricted Period”: Defined as the period (x) beginning five days before the
pricing of the offered securities and ending with pricing; or (y) beginning with the initial
filing of the registration or notification (if occurring less than 5 days before pricing) and
ending with pricing (whichever is shorter).
1. No knowledge qualifier; short sales effected during the applicable restricted
period generally prohibit participation in the offering even if the short sale
was effected at a time when the seller was not yet aware of the new offering.
a. Rule 105 as “prophylactic” in nature; short seller’s intent is not
relevant.

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2. “Prior Rule 105” vs. “Revised Rule 105”:
a. Prior Rule 105 may be characterized as a restrictive rule, whereas Revised Rule 105 may be
characterized as a prohibitive rule.
i. Prior Rule 105: Imposed restrictions on the use of offered securities to cover short
sales effected during the applicable restricted period.
ii. Revised Rule 105: Imposes a general prohibition on the purchase of offered
securities if the proposed purchaser effected any short sales in the subject securities
during the applicable restricted period.

b. SEC’s stated goals in revising Rule 105:
i. Reduce the incentive to aggressively sell short a subject security prior to pricing
solely in anticipation of the discount normally associated with offerings.
ii. Provide a “bright line” demarcation point for prohibited conduct consistent with the
overall policy goals of Regulation M.
iii. Address what the SEC views as continued violations of the rule, through the use of
trading strategies designed to accomplish the economic equivalent of the activity that
the rule sought to prevent.
1. Revised rule does not address use of derivative strategies. (See Section 4
below.)

3. Exceptions Available Under Rule 105:
a. Bona Fide Purchases:
i. Permits parties who have otherwise shorted the subject security from purchasing
offered securities if the purchaser effects a bona fide purchase of the subject security
prior to pricing.
ii. Conditions:
1. Purchases must be at least equivalent in quantity to all short sales in the
subject security effected during the Rule 105 restricted period;
2. Purchases must be effected during regular trading hours;
3. Purchases must be reported pursuant to an “effective transaction reporting
plan” (as defined in SEC Regulation NMS, Rule 600(b)(22));
4. Purchases must be effected (x) after the last short sale effected during the
Rule 105 restricted period and (y) not later than the business day prior to the
day of pricing; and
5. Party seeking to rely upon the exception must not have effected a short sale
in the subject security during the last 30 minutes prior to the close of regular
trading hours (i.e., 4pm, ET) on the business day prior to the day of pricing.

b. Separate Accounts:
i. Permits the purchase of offered securities in one account to the extent that short
sales in the subject security during the applicable restricted period were effected in
one or more separate accounts.
ii. Requires that decisions regarding securities transactions for each account are
independently made, without coordination of trading or any other form of cooperation
among the accounts.
1. Indicia of Separate Accounts:
a. Accounts have separate and distinct trading strategies and
objectives;
b. Personnel for each account do not coordinate trading among or
between the accounts;
c. Accounts do not share information regarding securities positions or
investment decisions;
d. Accounts maintain separate profit/loss statements;
e. There is no allocation of securities between/among accounts; and
f. Managers/Supervisors responsible for multiple accounts do not
have authority to manage the day-to-day trading in such accounts.
More specifically:
i. They do not have authority to execute trades in individual
securities and, in fact, do not execute trades in the
accounts; and

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ii. They do not have authority to pre-approve trading
decisions for the accounts and, in fact, do not pre-approve
trading decisions for the accounts.
2. Accounts not satisfying each of the indicia set forth in Section 3(b)(ii)(1)
above may still fall within the exception if accounts are otherwise separate
and operate without coordination or cooperation.
a. In Adopting Release, SEC emphasizes the use of policies and
procedures to ensure separateness of accounts and no
coordination/cooperation and effective ongoing monitoring to
ensure continued compliance.
i. Reviewing activities that are indicative of coordination; and
ii. Reviewing trading activity that appears inconsistent with
the stated trading strategy of the account.
iii. Fund of Funds: Fund that invests in multiple funds and which own shares of each
fund rather than shares of the underlying investments need not rely upon the
“separate account” exception.
1. Rationale: Shares held in each fund are distinct from the underlying (i.e.,
“subject” and “offered”) securities.
iv. Sub-advisor of Registered Investment Company: Sub-advisors generally viewed as
separate accounts, provided that:
1. Sub-advisors meet the elements of Rule 17a-10(a)(1)-(2) under the
Investment Company Act of 1940 (which, in relevant part, prohibits
coordination/cooperation among sub-advisors in executing securities
transactions for the fund); and
2. Primary investment advisor does not execute or pre-approve trading
decisions in individual securities for the sub-advisors.

c. Investment Companies:
i. Permits registered investment company to purchase offered securities, but only to the
extent that any short sales in the subject security during the applicable restricted
period are effected by either:
1. an affiliated investment company, or
2. a separate series of the investment company.
ii. Rationale: Provisions of the Investment Company Act of 1940 already generally
prohibit coordinated action between/among affiliated funds or between/among
different series of the same fund.
1. See generally, Section 17(d) and Rule 17d-1 of the Investment Company Act
of 1940.

4. Derivatives:
a. SEC declined to prohibit transactions in derivative securities that could achieve the economic
equivalent of short sales.

b. In Adopting Release, SEC states that they will continue to “…monitor and evaluate further
whether the link between the derivative trading and the underlying equities is sufficiently
attenuated as not to warrant additional regulation.”