Alert September 28, 2010

SEC Settles Enforcement Proceedings Over Regulation M Violations Related to Short Sales Outside the Separate Account Exception during the Restricted Period Prior to Purchases in a Public Offering

The SEC issued an order settling an enforcement action against a registered investment adviser  and manager of hedge funds (the “Adviser”) for violations of Rule 105 of Regulation M under the Securities Exchange Act of 1934 (“Rule 105”).  Rule 105 prohibits a person from buying an equity security made available through a public offering from an underwriter or broker or dealer participating in the offering after the person has sold short the same security during the Rule 105 restricted period beginning five business days before the pricing of the offering, or beginning on the date of filing of the registration statement, if less than five business days before pricing (the “Restricted Period”).  Rule 105 provides an exception for the purchase of an offered security in an account that is “separate” from the account through which the same security was sold short (the “Separate Account Exception”).

Violations.  In its order, the SEC found that during 2008, the Adviser violated Rule 105 with respect to follow-on or secondary offerings of four issuers (the “Offerings”).  In each case the Adviser was found to have directed the purchase of securities on behalf of a portfolio in the relevant Offering after having directed that securities of the same issuer be sold short within the Restricted Period.  In two of the transactions, the portfolios achieved significant gains.  In the other two transactions, the portfolios did not make a profit, because the offering price was greater than the short sale price, but the portfolios avoided some losses because the Offerings were priced at a discount to the market price.

Separate Account Exception Unavailable.  Three of the transactions involved purchases in the relevant Offerings on behalf of the same portfolio on whose behalf the securities were sold short during the Restricted Period.  In the fourth transaction the SEC found a violation of Rule 105 even though the portfolio that purchased the securities in the public offering was different from the portfolio that had sold the securities short during the Restricted Period.  The SEC acknowledged that the two portfolios had different portfolio managers.  Furthermore, the SEC noted that the portfolio that had the short position appeared to have purchased shares in the market sufficient to cover its short position.  Nevertheless, the SEC found that the two portfolios involved did not qualify for the Separate Account Exception, noting that the Separate Account Exception is available only where decisions regarding securities transactions for each portfolio are made separately and without coordination of trading or cooperation among or between the accounts.  In this regard, the SEC found that the Adviser’s structure permitted information to be shared across portfolios, that both portfolio managers were supervised by a Chief Investment Officer who had ultimate trading authority and that the portfolio managers involved did not make trading decisions separately.

Adviser’s Policies and Procedures. In making its findings the SEC stated that the Adviser did not have policies and procedures sufficient to prevent the Adviser from participating in the Offerings in violation of Rule 105.  The SEC found that at the time of the violations the Adviser’s compliance manual did not address Rule 105, that the Adviser had not conducted any formal firm-wide training addressing Rule 105 during the relevant time period, and that as a result, the Adviser’s investment personnel who directed the participation in the Offerings either misunderstood or were unaware of the requirements of Rule 105 when the violations occurred.  The SEC noted that the Adviser’s sole procedure relating to Rule 105 compliance was to rely on a single trader to coordinate the review of prior short sales before participating in offerings of securities, a procedure that was insufficient to prevent the violations. 

Remedial Action and Sanctions.   During the SEC’s investigation into the violations, the Adviser conducted firm-wide training addressing Rule 105, amended its compliance manual to include Rule 105, and implemented an automated system to facilitate Rule 105 reviews.  Under the terms of the settlement, which reflected the SEC’s consideration of the Adviser’s remedial efforts and cooperation, the Adviser is subject to a cease and desist order and censure, is required to pay a penalty of $260,000, and is required to pay disgorgement in the amount of $2,256,386 reflecting the amount of gain or avoidance of losses resulting from the violations.