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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FINRA Fines Brokerage Firm For Reverse Churning

FINRA fined Robert W. Baird & Co. $500,000 for supervisory violations relating to its fee-based brokerage accounts. FINRA also ordered Baird to return $434,510 in fees to 154 customers. FINRA found that customers were charged fees in accounts that were not generating any activity, otherwise known as “reverse churning.”

According to FINRA Baird failed to adequately review or supervise its fee accounts and allowed numerous customers to remain in the program despite conducting no trades for at least eight consecutive quarters. These accounts paid over $269,000 in fees during the inactive quarters.

According to Andrew Stoltmann at Investmentfraud.PRO, this type of fee based account has become more prevalent in the past 7 years and Baird is only one firm out of many who engaged in so-called reverse churning. Recent actions involving firms such as AXA Advisors, Morgan Stanley, SunTrust Investment and Wachovia Securities ranged from $700,000 to $6.1 million.

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SEC Approves New FINRA Rule Requiring Arbitrators to Provide Explanation

Under the new rule, parties to an arbitration may require an arbitrator to provide an explanation of decision if the request is made jointly (by both parties) 20 days prior to the first scheduled hearing date. An arbitrator must provide a fact-based award stating the general reason(s) for the arbitrator's decision. However, the rule does not require the arbitrator to include legal authorities and/or damage calculations.

The chairperson required to write the explained decision will receive an additional honorarium of $400 and will allocate the cost to one party or between/among all parties. The 20 day deadline coincides with the time that parties must exchange documents and identify witnesses they intend to present at the hearing. In FINRA's view, this establishes a clear deadline, gives the parties sufficient time to request an explained decision, and provides notice to the arbitrators that an explained decision will be required before the hearing begins.

The new rule is likely an attempt by FINRA to appease a common perception among customers that the arbitration process favors the industry. Although FINRA has conducted studies and published results that tend to discredit the validity of industry favoritism, FINRA maintains that the mere perception of inequity is a concern that they are taking steps to eradicate.


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Securities Litigators Suggest It Pays To Fight Proceedings Brought By SEC/FINRA

Two broker-dealer side securities litigators from Sutherland Asbill & Brennan LLP conducted a study that concluded broker-dealers can benefit from fighting proceedings brought by the SEC and FINRA. The study says that firms who fought proceedings brought by the SEC won a dismissal 19% of the time and FINRA complaints that were fought were dismissed 15% of the time. With regard to fines, respondents to SEC charges convinced the judge to lower the fines 83% of the time and FINRA respondents succeeded in reducing fines roughly 50% of the time.

Another interesting but not surprising statistic published by the study is that respondents who hired counsel were overwhelmingly more successful than those that did not. SEC respondents represented by counsel succeeded in getting approximately 22% of charges dismissed, and FINRA respondents with counsel succeeded in getting approximately 19% of charges dismissed. SEC and FINRA respondents without counsel went 0-for-16 from January 2006 through December 2007.


Clearly, the terrible rate of success for pro-se respondents is a testament to the unfortunate pay-to-play factor in our justice system that favors those with resources to hire a lawyer. However, another possible factor not discussed in the study is that a respondent who believes he or she is guilty or liable, may be less likely to fight or spend money on counsel. If true, this factor would slightly skew the pool of pro-se respondents towards a lower “success” rate.

Read the study results here.



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Second Circuit Rules that Class Action Waiver Provision Violates the Federal Arbitrations Act

In In re: American Express Merchants' Litigation, 06-1871-cv, decided on January 30, 2009, the Second Circuit ruled for the first time that the class action waiver provision within a contract between American Express Co. and merchants is unenforceable under the Federal Arbitration Act. The Court held that to enforce this agreement would "grant Amex de facto immunity from antitrust liability by removing the plaintiffs’ only reasonably feasible means of recovery."

The Court did not go so far as to rule that class action waiver provisions are either void or enforceable per se, focusing solely on the provision contained in the specific contract being argued before them.

The Court also held that the authority to determine the enforceability of a class action waiver is a matter for the courts, not the arbitrator.

Plaintiffs - two groups of business operators who have contracts with the company and a trade association that represents independently owned supermarkets - filed suit against American Express, claiming that they were forced to agree to accept all American Express credit and debit cards as a cost of doing business with the company. The agreement prevents the filing of a class action lawsuit. The complaint alleged an illegal 'tying arrangement' in violation of §1 of the Sherman Act.

The District Court had granted American Express’s motion to compel arbitration. The Second Circuit held that "the enforcement of the Card Acceptance Agreement to cover their claims against Amex under federal antitrust statutes would be incompatible with the federal substantive law of arbitration."

The Court recognized the general principle that "the class action device is the only economically rational alternative when a large group of individuals or entities has suffered an alleged wrong, but the damages due to any single individual or entity are too small to justify bringing an individual action." Further, the "record abundantly supports the plaintiffs' argument that they would incur prohibitive costs if compelled to arbitrate under the class action waiver."

"The Card Acceptance Agreement therefore entails more than speculative risk that enforcement of the ban will deprive them of substantive rights under the federal antitrust statutes."

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Third Circuit Decision on the Statute of Limitations

In Alaska Electrical Pension Fund v. Pharmacia Corporation, Case Nos. 07-4500 & 07-4564, 2009WL213095 (3d Cir., Jan. 30, 2009), the court vacated an order from the district court granting summary judgment for defendants based the statute of limitations in a securities fraud class action. The application of the statute of limitations here was keyed to the question of ‘inquiry notice’, the point at which a reasonable investor has a duty to inquire.

Based on doctored versions of a scientific study, Celebrex - an anti-inflammatory drug distributed by the defendants - was claimed to cause fewer gastrointestinal side effects than its competitors. This claim was questioned by the FDA. Months later, following a series of positive statements about Celebrex, a major national paper reported that defendants withheld the full scientific study.

Key to the issue of statute of limitations is when an investor is placed on inquiry notice. A court will examine when the plaintiffs (“reasonable investors of ordinary intelligence”), through reasonable diligence, should have sufficient information of possible wrongdoing by defendants. Inquiry notice functions to deter punitive plaintiffs from sitting on their hands, and is triggered when plaintiffs should have discovered the general fraudulent scheme.

Reasonable investors, following reasonable diligence, are “presumed to read prospectuses, quarterly reports, and other information relating to their investments.” Courts also look to see if investors ignored ‘storm warnings’ (i.e. suspicions of corporate mischief). However, an ordinary investor need not be a scientific expert, with no requirement that an investor shift through lengthy collections of scientific data to determine what happened.

In the present case, the district court held the plaintiffs were under inquiry notice at the time of the initial FDA examination of Celebrex and therefore granted summary judgment to defendants. The Third Circuit disagreed. Merely relying on a good faith scientific disagreement between the company and the FDA was not sufficient to trigger inquiry notice since there was no indication of wrongful conduct or scienter necessary to maintain a securities fraud claim. Inquiry notice occurred months later following the disclosure of the full medical report on Celebrex.

Further, in attempting to calm investors, defendants issued statements to reassure the market following the FDA accusation. This had the effect of dissipating any ‘storm warnings’ and prevented plaintiffs from being put on inquiry notice.


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Interim CEO Of FINRA Testifies Before US House Of Rep Re Madoff

Although Luparello's testimony was comprehensive, the overarching theme was that disparate treatment by fractured regulatory authorities fosters failed oversight. His testimony emphasized the need for "a consistent level of protection no matter which financial professionals or products [investors] choose." See his entire testimony here.

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SEC Approved Another FINRA Proposal

The SEC approved FINRA's proposal to amend the amount in controversy that may be heard by a single arbitrator to 100k.

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Securities Litigators in High Demand

Experienced securities litigation practitioners have been in high demand due to many factors, including the Madoff scandal, poor economy, and changing regulatory environment. According to the Legal Intelligencer (password required), this fact has lead to prominent securities litigators trading their smaller, regional firms to firms with a national or international arena.

The article cites the recent moves of Alexander Bono (previously of Schnader Harrison Segal & Lewis, now Duane Morris), Tim Hoeffner (formerly of Saul Ewing, now DLA Piper), and M. Norman Goldberger (formerly of Hangley Aronchick Segal & Pudlin, now Ballard Spahr Andrews & Ingersoll) (seen here). Bono cites the larger capacity of Duane Morris over his previous firm as a deciding factor in his departure. Bono points to non-litigation support that arise out of securities litigation cases that a major firm can supply, including Sarbanes-Oxley concerns, corporate governance matters, filing regulations and other non-litigation securities assistance.

He also feels that it will become increasingly difficult for smaller firms to manage the work coming from companies as litigation looms. Ralph Wellington, chairman of Schnader Harrison disagrees, stating that clients care mostly about the reputation and strength of the representing firm, not the firm size.



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