Proposed Amendments to Rule 10a-1 under the Exchange Act and Rule 105 of Regulation M

At its open meeting yesterday, the Securities and Exchange Commission (the “Commission”) voted to propose:

(i) an amendment to Rule 105 of Regulation M that would prohibit any person who sells short during the Rule 105 pre-pricing period for an offering from purchasing any securities in that offering; and

(ii) amendments that would eliminate the short sale “tick” test of Rule 10a-1 and all short sale price tests adopted by self-regulatory organizations (“SROs”).

Regulation M Proposal: Under Rule 105 of Regulation M, it is presently unlawful (subject to limited exceptions) for any person to cover a short sale with offered securities purchased from an underwriter or broker-dealer participating in a firm commitment offering of securities for cash pursuant to a registration statement or notification of Form 1-A, if the short sale occurred during the period ending with the pricing of the offering and beginning on the later of (1) the fifth business day before pricing, or (2) the initial filing of the registration statement or notification on Form 1-A (the “pre-pricing period”). The Commission’s proposal would eliminate the “covering” component of the current prohibition and make it unlawful for a person who sold short during the pre-pricing period to purchase securities in the offering -- even if the securities purchased in the offering were used for a purpose other than to cover the short sale. This “bright-line rule” is intended to put an end to the progression of schemes that have been engineered to camouflage covering activity that is already prohibited by Rule 105, to streamline compliance with Rule 105 and to facilitate enforcement of Rule 105.

Several interesting points were raised in the course of the Commission’s discussion of the Regulation M Proposal:

• Commissioner Roel C. Campos asked the staff of the Division of Market Regulation to elaborate on the responsibility for compliance with Rule 105. The staff affirmed that the responsibility for compliance would continue to lie with the trader who would be selling short during the pre-pricing period and then taking an allocation in the offering. As with other rules, a broker-dealer involved in the transaction could also be implicated under the standards for aiding and abetting liability. According to the staff, although it is probably not possible for an underwriter to know that a customer executed a restricted short sale away from the underwriter, underwriters and investment bankers would need to respond to “red flags” as to possible violations by their customers that they could be facilitating if they knew about the possible violations and lent substantial assistance. The staff acknowledged that, absent knowledge on the underwriter’s part and satisfaction of the aiding and abetting standards, the primary responsibility for compliance would rest with the trader and not the underwriter.
  
  
• Commissioners Paul S. Atkins and Annette L. Nazareth expressed concerns about the fact that Rule 105 does not have a scienter requirement and may therefore pose a “trap for the unwary.” In response, the staff noted that, if a scienter requirement were incorporated into the rule, enforcement would be time-consuming and burdensome and may not catch all instances of manipulative activity. Nonetheless, Commissioner Atkins suggested that the release seek comment as to whether a scienter requirement should be included in the rule.
  
  
• Commissioner Atkins also mentioned recent cases involving short sales effected in connection with private investment in public equity (“PIPE”) transactions. He asked the staff whether the proposed amendment to Rule 105 will address such transactions. The staff responded that Rule 105 is presently limited to transactions underwritten on a firm commitment basis and therefore does not cover PIPE transactions, but noted that the release will seek comment on whether the rule should be expanded to address such transactions.
  
  
• In response to a question from Commissioner Kathleen L. Casey, the staff noted that the release will also seek comment on whether Rule 105 should address the use of trading strategies involving options or other derivatives that could produce effects similar to short sales.
  

Rule 10a-1 Proposal: Under the “tick test” of Rule 10a-1 under the Securities Exchange Act of 1934, which covers short sales in listed securities (other than NASDAQ securities), a covered security currently may not (subject to certain exceptions) be sold short at a price below the price at which the immediately preceding sale was effected (“minus tick” or “down tick”) or at the last sale price if it was lower than the last different price (“zero-minus tick”). Under the short sale “bid test” presently set forth in NASDAQ Rule 3350 and NASD Rule 5100, short sales of NASDAQ Global Market Securities executed on NASDAQ or reported to the NASD may not (subject to certain exceptions) be effected at a price at or below the current best (inside) bid when the current best (inside) bid is below the preceding best (inside) bid in the security. In conjunction with its adoption of Regulation SHO in 2004, the Commission established a Pilot Program which, beginning May 2005, exempted from the Rule 10a-1 tick test, the NASD/NASDAQ bid test and any other SRO short sale price tests (i) all short sales in the approximately one third of the securities in the Russell 1000 index that were designated as “Pilot Securities”, (ii) short sales executed between 4:15 p.m. and the opening of the consolidated tape in any securities in the Russell 1000 index and (iii) all short sales executed between the close of the consolidated tape on one day and the open of the consolidated tape on the next day. According to the Commission, analysis of the data generated by the Pilot Program provided little empirical justification for maintaining short sale price test restrictions, at least for those stocks in the pilot. As a result, the Commission is now proposing to remove all restrictions on the execution price of short sales by eliminating the Rule 10a-1 “tick test” and prohibiting SROs from maintaining existing price tests or adopting new ones.

The Commission’s full release, including the text of the proposed amendments, is not yet available. The webcast of the open meeting may be found at http://sec.gov/news/openmeetings.shtml.

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