Short selling around an offering

Rule 105 of Regulation M makes it unlawful to buy securities in a registered offering from an underwriter, broker or dealer participating in it if you sold that security short during the restricted period before pricing. It is prophylactic: no manipulative intent is required. It reaches firm-commitment registered offerings, and not an unregistered PIPE.

Key takeaways

• The rule bites on the purchase, not on the short sale. It prohibits buying the offered securities from a participating underwriter, broker or dealer after a short sale made in the restricted period (17 CFR 242.105(a)).
• The restricted period is the shorter of two measures. Five business days before pricing to pricing, or the initial filing of the registration statement or the Form 1-A or Form 1-E notification to pricing.
• Two gates decide scope. The offering must be of equity securities for cash under a registration statement or a Form 1-A or 1-E notification, and Rule 105(c) excepts any offering not on a firm commitment basis. An unregistered PIPE fails the first; a best-efforts registered direct the second.
• No intent is required, which is why enforcement is routine. The rule carries no scienter element, so the elements of a violation are a trade blotter and a pricing date.

What Rule 105 actually prohibits

Rule 105 sits inside Regulation M, the anti-manipulation rules for trading around a distribution, at 17 CFR 242.105. It does not ban short selling before an offering. It prohibits the combination: a short sale of the offered security during a defined window before pricing, followed by a purchase of the offered securities from an underwriter, broker or dealer participating in that offering.

The selling limb takes its meaning from Rule 200(a) of Regulation SHO — a sale of a security the seller does not own, or one consummated by the delivery of a borrowed security. Before the rule was amended in 2007 the prohibition ran to covering a restricted-period short position with securities bought in the offering, so the analysis turned on which shares had gone where. It now attaches to the purchase itself, and tracing is irrelevant.

There is no state of mind to establish. Nothing in the text asks why the short sale was made or whether the price moved, which is what makes Rule 105 prophylactic rather than a manipulation case. Two facts decide it: the timestamps on the short sales, and the moment of pricing.

The restricted period, measured two ways

Rule 105(a) defines the Rule 105 restricted period as the shorter of two periods. The first begins five business days before the pricing of the offered securities and ends with that pricing. The second begins with the initial filing of the registration statement, or of the notification on Form 1-A or Form 1-E, and ends with that pricing.

Two consequences follow. For a takedown from a shelf effective for a year the registration statement was filed long ago, so the five-business-day measure governs; for a deal priced within days of an initial filing the filing-to-pricing measure can be shorter. Both end at pricing: not announcement, not signing, not closing.

Which financings it reaches, and which it does not

Two gates have to be passed before Rule 105 applies, and this is what matters most to an issuer choosing between structures.

The first is in the opening words of Rule 105(a): the offering must be of equity securities for cash made pursuant to a registration statement, or pursuant to a notification on Form 1-A or Form 1-E filed under the Securities Act (the rule still says “notification”; since 2015 a Regulation A offering is made under a qualified offering statement on Form 1-A). A private placement made under an exemption is not such an offering, which is why a private investment in public equity sits outside the rule on its own terms; the resale registration statement, where there is one, is filed afterwards and registers a resale by the holder rather than the original sale by the issuer.

Rule 105 is simply not the rule doing the work there. What is: the anti-fraud provisions, the wall-crossing discipline described on the PIPE transaction page, and Section 5 of the Securities Act. The Commission's long-held position is that closing a short opened before announcement with the placement shares is an unregistered distribution of those shares. The analysis is fact-specific and has been litigated both ways, but it is why a PIPE purchase agreement takes a short-sale representation at all.

The second gate is Rule 105(c), which excepts offerings not conducted on a firm commitment basis, and it cuts the other way. A firm-commitment underwritten follow-on, in which the syndicate buys the book and resells it, is squarely inside the rule. A registered direct offering is normally placed by a broker-dealer as placement agent on a best-efforts basis, so it falls within the paragraph (c) exception even though it is fully registered. The same reasoning reaches an at-the-market programme.

Answer both questions in order, on the specific deal, not from the label on the term sheet. Registered does not mean in scope; private does not mean unconstrained.

The three exceptions in Rule 105(b)

Rule 105(b) contains three exceptions, and only three. The bona fide purchase exception is the one intended to be usable. It permits the purchase where the person has made bona fide purchases of the security at least equivalent in quantity to the entire amount of the restricted-period short sales, made during regular trading hours, reported to an effective transaction reporting plan, and effected after the last restricted-period short sale and no later than the business day before the day of pricing. A second condition is easy to miss: no short sale reported to such a plan may have been effected within the 30 minutes before the close of regular trading hours on that business day. Every limb counts: a purchase short of the aggregate quantity, or made on the pricing day rather than the day before, cures nothing.

The separate accounts exception permits the purchase in one account where the short sale was made in a separate account, provided decisions on securities transactions for each account are made separately and without coordination of trading or cooperation between them. The test is behavioural rather than documentary.

The investment company exception permits the purchase in the account of a registered investment company where the restricted-period short sale was made by an affiliated investment company in the same group of investment companies, or by a separate series of the same registered investment company.

Nothing else excuses the purchase: no de minimis threshold, no general exception for a hedge, and none for a short sale placed before the seller knew of the offering.

The rest of Regulation M: Rules 100 to 104

Rule 105 is the last of the six rules that make up Regulation M, and an issuer running a distribution is more likely to be caught by one of the others.

Rule 101 restricts bids for and purchases of the security being distributed by distribution participants — underwriters, brokers and dealers participating in it — and by their affiliated purchasers. Rule 102 imposes the parallel restriction on the issuer and on selling security holders. Both take their restricted period from the definition in Rule 100: it begins on the later of one business day before pricing or the time the person becomes subject to the rule, where the security has an average daily trading volume value of $100,000 or more and the issuer's common equity a public float value of $25 million or more, and five business days before pricing for everything else. It ends on completion of participation in the distribution.

Rule 101(c)(1) excepts actively-traded securities — an average daily trading volume value of at least $1 million where the issuer's common equity has a public float value of at least $150 million, provided the security was not issued by the distribution participant or an affiliated purchaser. Rule 102 gives the issuer no equivalent exception for its own security in distribution.

Rule 103 runs the other way. It is a safe harbour rather than a prohibition, letting a Nasdaq market maker that is a distribution participant carry on passive market making through the restricted period on stated bid, size and volume conditions.

Rule 100 also supplies the definition Regulation M turns on. A distribution is an offering distinguished from ordinary trading transactions by the magnitude of the offering and by the presence of special selling efforts and selling methods — a facts-and-circumstances test, and where there is no distribution there is no restricted period under Rules 101 and 102. Rule 104 then governs stabilisation, permitted only to prevent or retard a decline in the market price, at prices the rule caps, disclosed in the offering documents, identified as a stabilising bid and notified in advance to the market on which it is entered.

What this means on the issuer's side of the table

Rule 105 binds the buyer, not the issuer. It still lands on the issuer's desk in four places, all cheap to settle early.

1. Fix the pricing moment in the documents

   Every measurement in the rule ends at pricing. Say in the engagement letter and the purchase agreement what pricing means on this transaction and when it occurs.

2. Take the representation at account level

   Where the offering is in scope, the investor representation should cover restricted-period short sales and any exception relied on. If a buyer subscribes for several accounts, take it account by account — the level the separate accounts exception works at.

3. Sequence the buyback against the raise

   Rule 102 is the provision an issuer can breach itself. A repurchase programme running into a distribution is the common fact pattern, and the actively-traded exception in Rule 101 is not available to the issuer.

4. Watch the reference price, not only the rule

   Nasdaq Listing Rule 5635(d) applies to a transaction other than a public offering, and IM-5635-3 makes that a facts-and-circumstances test, so it reaches a private placement, and can reach a registered offering placed narrowly at a discount. Its Minimum Price is the lower of the closing price before signing and the five-day average; pressure before signing lowers both, and moves where the 20% Issuance test bites. The rule is set out on this site under the Nasdaq 20% rule.

None of this changes the choice of instrument; it changes the order of the questions. The structures are set out on the instruments hub, the two routes are compared on PIPE versus registered direct, and resale is on Rule 144.

Related reading

• All insights
• How a registered direct is placed
• Check whether you qualify

Primary sources

• eCFR — 17 CFR 242.105, Rule 105 of Regulation M
• eCFR — 17 CFR 242.100, Regulation M preliminary note and definitions
• eCFR — 17 CFR 242.101, activities by distribution participants
• eCFR — 17 CFR 242.102, activities by issuers and selling security holders
• eCFR — 17 CFR 242.103, Nasdaq passive market making
• eCFR — 17 CFR 242.104, stabilizing and other activities
• eCFR — 17 CFR 242.200, definition of short sale
• Cornell LII — 15 U.S.C. 77e, Section 5 of the Securities Act
• Nasdaq Listing Rules — Rule 5635(d) and IM-5635-3

Rule 105: frequently asked questions

Does Rule 105 apply to a PIPE?

Not on its own terms. Rule 105 applies to an offering of equity securities for cash made pursuant to a registration statement or a notification on Form 1-A or Form 1-E. A PIPE is sold under an exemption from registration, so the first condition in Rule 105(a) is not met and the rule is not engaged. That is not a clearance. The anti-fraud provisions and the wall-crossing discipline still apply, and Section 5 of the Securities Act is the constraint the Commission has invoked where a short opened before announcement is closed with the placement shares.

What is the Rule 105 restricted period?

Rule 105(a) defines it as the shorter of two periods. The first begins five business days before the pricing of the offered securities and ends with that pricing. The second begins with the initial filing of the registration statement, or of the notification on Form 1-A or Form 1-E, and ends with that pricing. Only the start date moves. For a takedown from a shelf that has been effective for months the five-business-day measure is almost always the shorter one.

Does Rule 105 apply to a registered direct offering?

Usually not, and the reason is Rule 105(c) rather than the registration status: it excepts offerings that are not conducted on a firm commitment basis. A registered direct offering is normally placed by a broker-dealer as placement agent on a best-efforts basis, so it falls within that exception even though it is fully registered. How a particular offering is characterised is a question of fact for counsel.

Can a short seller cure a Rule 105 problem before pricing?

Only through the bona fide purchase exception in Rule 105(b)(1), and only if every limb of it is satisfied. The purchases must be at least equivalent in quantity to the entire amount of the restricted-period short sales, effected during regular trading hours, reported to an effective transaction reporting plan, and effected after the last restricted-period short sale and no later than the business day before the day of pricing. No short sale reported to such a plan may have been effected in the 30 minutes before the close of regular trading hours on that business day. Closing the position by another route is not a cure.

Does the issuer breach Rule 105 if an investor does?

No. Rule 105 is addressed to the person who sells short and then buys the offered securities, not to the issuer, and a violation by a purchaser does not invalidate the offering. The issuer's exposure is practical rather than legal: a representation in the purchase agreement that turns out to be untrue, an investor who has to unwind, and a diligence question on the next financing. The Regulation M rule an issuer can itself breach is Rule 102.