Revisiting Regulation M, Rule 105: Short Selling Initial and Secondary Offerings

Securities and Exchange Commission 17 CFR Part 242. Release No. 34-56206. Short Selling in Connection with a Public Offering.

Current economic conditions lend itself to increased short selling and, consequently, shorting has come under increased scrutiny by the SEC. Rule 105 of Regulation M 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).

Put another way, two actions have to occur to trigger a violation of Rule 105:

1)Short sale of a stock within the 5 days before it is priced (the “restricted period”) for an initial or secondary offering.

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

Before Rule 105 was amended on October 9, 2007, the rule prohibited “covering” a short sale with a stock received as part of an offering, if the short sale took place within the 5 days before pricing. The amended rule replaced the word “cover” with “purchase.” Thus, under the current rule, a mere purchase made as part of an offering triggers a violation – you do not have to complete the short, or cover, to be in violation.

The three exceptions to Rule 105 are the “bona fide purchase exception,” the “separate accounts exception,” and the “investment company" exception. SIFMA provides an explanation of each on its website here.

According to the SEC, the goal of Rule 105 is to maintain the integrity of the offering price by ensuring its is based on market forces (supply and demand) and not “artificial forces" (market manipulations). In the SEC's view, pre-pricing short sales that are covered with offering shares artificially distort the market price. See entire rule, here.


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