SEC "Zero Tolerance" Nets Nearly Two Dozen Firms for Alleged Violations of Short Sale Rule

by BakerHostetler
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Hedge fund and other private investment fund managers, both domestic and foreign, those registered or not, beware. SEC Chairman Mary Jo White's crackdown on securities violations continued last Tuesday with the announcement of 23 enforcement actions against stock market participants and an individual for alleged violations of the Short Sale Rule -- Rule 105 of Regulation M of the Securities Exchange Act of 1934.[1]

Rule 105 generally prohibits the short sale of an equity security during a restricted period -- typically five business days — and the purchase of that same security through a follow-on or secondary offering. The Rule is applicable regardless of the trader's intent and with exceptions for bona fide purchases, separate accounts and registered investment companies. The purpose of the Rule is to promote offering prices set by natural forces of supply and demand rather than manipulative activity, which artificially depresses the market price for the security shortly before the offering.[2] This effort, like the crackdown on insider trading, demonstrates the SEC's lack of tolerance for securities violations, even when the dollar amounts involved are small.

STREAMLINED INVESTIGATIONS AND RESOLUTIONS

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." Ceresney also stressed that the Staff's "new program of streamlined investigations and resolutions of Rule 105 violations . . . send[s] the clear message that firms must pay the price for violations while also conserving agency resources."

The facts and circumstances relating to the enforcement actions underscore Ceresney's remarks in several key aspects and highlight other SEC developments and initiatives.

  • First, the investigations and resolutions process relating to these enforcement actions was highly streamlined given reports only this past summer that the SEC had requested information from financial firms about potential Rule 105 violations.
  • Second, the enforcement actions were brought against a wide variety of respondents, including foreign and domestic investment advisers (both registered and unregistered with the SEC) of hedge funds, registered broker-dealers, private equity firms and an administrator of a foreign pension fund.
  • Third, the enforcement actions exhibit the SEC's "zero tolerance" for Rule 105 violations, regardless of the financial benefit to the respondent. Six of the respondents engaged in merely one allegedly unlawful short sale. One of the respondents received only $4,091 in illicit profits from its alleged violation.
  • Fourth, in all cases, hefty penalties even for minor monetary infractions were obtained. It seems a minimum penalty was $65,000 (e.g., Credentia Group and Merus Capital Partners). In other cases, approximately one-half of the improper profit was obtained (e.g., D.E. Shaw & Co. and Deerfield Management Company). In others, an amount approximately equal to the profits plus interest was obtained (e.g., Blackthorn Investment Group and PEAK6 Capital Management). Perhaps the number of violations and alacrity with which the remedial efforts and cooperation occurred had something to do with this disparate treatment on the penalties.
  • Fifth, all but one of the enforcement actions were settled without the respondents admitting or denying the allegations. This indicates that, despite the SEC's new policy of requiring admissions of wrongdoing in certain cases (as we discussed in a recent alert involving the Falcone/Harbinger Settlement), it still enters into "no admit, no deny" settlements.
  • Finally, the consent orders demonstrate the SEC's continued implementation of its Cooperation Initiative (as we discussed in our Mid-Year Report). 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.[3]

It appears from these enforcement actions that the investigations of Rule 105 violations (and perhaps other per se violations of securities laws) are now on a fast track at the SEC. It is equally clear that the SEC intends to be aggressive with enforcing all aspects of the federal securities laws and rules, regardless of the size or the wrongdoer's financial benefit. Moreover, as always, the SEC is targeting all forms of market participants — broker-dealers and hedge fund and private equity managers — appearing to make the point that the SEC is fully engaged in all aspects of the industry.

COMPLIANCE PROGRAMS

In light of the foregoing, 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. As indicated in the SEC's National Examination Program Risk Alert[4] (which was simultaneously announced with the enforcement actions), compliance programs at such firms should be reasonably designed to ensure that the firms can avail themselves of Rule 105's "separate accounts" exception by, among other things:

  • Including regular reviews and training to ensure that the program is up to date and fully implemented;
  • Implementing information barriers;
  • Requiring separate profit and loss statements for each account; and
  • Restricting personnel with management or oversight responsibilities from allocating securities between or among accounts or executing or pre-approving trades.[5]

The importance of a compliance program with respect to protecting against Rule 105 violations cannot be overstated. Indeed, the Risk Alert notes that "[a]fter-the-fact remediation [does] not absolve a firm or individual from the violation of Rule 105." However, instituting appropriate policies, procedures and controls prior to the detection of a violation will help prevent Rule 105 violations from occurring and may ultimately absolve a firm for a violation if it occurs.[6]

[1] SEC Charges 23 Firms With Short Selling Violations in Crackdown on Potential Manipulation in Advance of Stock Offerings, SEC Immediate Rel. No. 2013-182 (Sept. 1, 2013).
[2] Short Selling in Connection with a Public Offering: Amendments to Rule 105 of Regulation M, SEC Small Entity Compliance Guide (May 21, 2008).
[3] In the Matter of M.S. Junior, Inc., Swiss Capital Holdings, and Michael Stango, SEC Exchange Act Rel. No. 70400, Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order and Civil Penalty (Sept. 16, 2013).
[4] Rule 105 of Regulation M: Short Selling in Connection with a Public Offering, SEC National Exam Program Risk Alert (Sept. 17, 2013).
[5] Final Rule: Short Selling in Connection with a Public Offering, SEC Release No. 34-56206, at 19-24 (Aug. 6, 2007).
[6] While the SEC has yet to publicly absolve any Rule 105 violations, it has in other circumstances decided not to bring an enforcement action against a firm where, among other things, that firm's compliance program was adequately tailored to protect against the violations of securities laws at issue. See, e.g., SEC Charges Former Morgan Stanley Executive with FCPA Violations and Investment Adviser Fraud, SEC Immediate Rel. No. 2012-78 (Apr. 25, 2012), (opting not to charge Morgan Stanley with FCPA violations committed by a rogue employee where, among other things, Morgan Stanley had tailored and implemented a compliance program to reasonably protect against the occurrence of such a violation).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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