SELLING SHORT BEFORE AN OFFERING: AN EVOLVING POSITION

The SEC filed two settled administrative proceedings based on selling short in advance of an offering. While the cases themselves are routine, read in conjunction with others, they may confirm that enforcement has adopted a different approach on this issue. In the Matter of First New York Securities LLC, Adm. Proc. File No. 3-13656 (Filed Oct. 20, 2009); In the Matter of Perceptive Advisors LLC, Adm. Proc. File No. 3-13657 (Filed Oct. 20, 2009).

Each case revolves around an alleged violation of Rule 105 of Regulation M, “Short Selling in Connection with a Public Offering.” That regulation provides, in part, that it is unlawful to cover a short sale with securities acquired from an offering for cash made pursuant to a Securities Act registration statement if the short sale occurs during the five business days before the pricing of the offering and ending with its pricing.

New York Securities is alleged to have violated the Regulation in two instances, once in September 2005 and a second time in January 2007. Overall, the firm made profits of just under $40,000. Perceptive Advisors is alleged to have violated the Regulation in five instances during 2005, yielding profits of about $245,000.

Both firms settled. Each consented to the entry of a cease and desist order from committing or causing any violations and future violations of Rule 105 of Regulation M. In addition, First New York agreed to pay disgorgement of just over $39,000, prejudgment interest of about $9,400 and a civil penalty of $20,000. Perceptive Advisors agreed to pay disgorgement of about $245,000, prejudgment interest of about $68,800 and a civil penalty of $125,000. In both instances, the Commission stated that it considered the remedial acts and cooperation of the Respondent.

These cases appear to represent the final evolution of the SEC’s position on selling short prior to an offering. Previously, the Commission brought a series of cases focused on PIPE offerings and hedge funds. In those cases, typically the fund which learned about the offering had some sort of agreement to keep the information confidential. Before the announcement of the offering, the Fund then sold short and later covered that position with the shares from the offering. Since the PIPE could be expected to dilute the value of the outstanding shares, the short could be closed at an advantageous price.

In the PIPE cases, the fund and its operators were typically charged with violations of Exchange Act Section 10(b) and Securities Act Section 5. Most settled. See, e.g., SEC v. Friedman, Billings, Ramsey & Co. Civil Action No. 06-cv-02160 (D.D.C. Jan 4, 2007), discussed here.

In those which were litigated however, the SEC lost the Section 5 claim. See, e.g. SEC v. Mangan, Civil Action No. 06-cv-531 (W.D.N.C. April 25, 2006), discussed here. In some cases, such as Mangan it also lost the fraud claim. In others, the fraud claim settled. See, e.g., SEC v. Lyon, Civil Action No. 06 CV 14338 (S.D.N.Y. Filed Dec. 12, 2006).

Following those losses, the Commission appeared to have dropped the Section 5 claim but persisted with the Section 10(b) insider trading allegation. See SEC v. Ladin, Civil Action No. 1:08-CV-01784 (D.D.C. Filed Oct. 20, 2008), discussed here.

The two administrative proceedings filed today, read against the backdrop of the PIPE cases, appear to represent the current evolution of this type of case. To be sure, these cases do not contain the confidentiality agreements alleged in Mangan and similar cases. Cuban, discussed here, had such an agreement. The Commission’s appeal of its loss there clearly demonstrates the agency will continue to pursue that type of claim. At the same time, the two administrative proceeding brought today may confirm what Ladin suggested. In the future, the Section 5 claim will be omitted in some cases while in others a Rule 105 charge will be used when appropriate.

THE SEC/CFTC REPORT ON HARMONIZATION: ENFORCEMENT

The SEC and the CFTC released “A Joint Report of the SEC and CFTC on Harmonization of Regulation” on Friday, October 16, 2009. The report was prepared pursuant to the Treasury White Papers released last June, and discussed here, which called for the two agencies to work together in an effort to harmonize their regulatory approaches. The report is supposed to be a part of comprehensive financial regulatory reform. The Administration sent proposed legislation up to Capitol Hill following the release of the White Paper. Various committees are considering the issues presented by that proposed legislation, as well as the market crisis.

Part of the Joint Report discusses enforcement, making recommendations for proposed legislation as part of the overall effort to harmonize the regulatory approaches of the two agencies. Overall the enforcement segment of the report focuses on manipulation, insider trading and aiding and abetting authority.

First, as to manipulation, the Report notes that both agencies have authority in this area. While there is some overlap in the types of cases brought, there are different issues in the futures markets involving activities such as corners and squeezes. The authority of the CFTC with respect to disruptive trading practices is, however, limited and needs to be enhanced.

Second, a key area of difference is insider trading. The market integrity provisions of the securities laws prohibit insider trading. In this regard there is a developed body of law regarding the use of corporate material non-public information and the duties of corporate officials and personnel.

The CEA’s insider trading prohibitions, in contrast, focus on employees and agents of the CFTC and of SROs and markets regulated by the agency. Historically, the markets have permitted hedgers to use their non-public material information to protect themselves against risks to their commodity positions. Counterparties to these transactions may not have access to the same kind of information. Corporate officials and personnel generally do not have a similar fiduciary duty with respect to those counterparties. Rather, their duty is to properly protect against risk. Some extension of the insider trading prohibitions under the futures laws is appropriate, according to the report. This would include an extension of the prohibitions applicable to CFTC and registered entity personnel to all SROs, government agencies and members of Congress.

Third, there are differences in enforcement remedies. For example, the CFTC has specific statutory authority for aiding and abetting all violations of the Act it administers and its regulations. The SEC in contrast does not. At the same time, neither agency has the ability to rely on whistleblowers to assist in detecting violations of the statutes.

The report makes five recommendations with respect to enforcement matters:

1) Whistleblowers: There should be legislation on whistleblower protections to encourage individuals to come forward with relevant information.

2) Restitution: There should be legislation to clarify that in CFTC civil actions that restitution is defined in terms of the losses sustained by persons as a result of the unlawful conduct.

3) Disruptive trading practices: There should be legislation to enhance the CFTC’s authority over disruptive trading practices.

4) Insider trading: There should be legislation to expand the scope of insider trading prohibitions under the CEA to make it unlawful to misappropriate and trade on the basis of material non-pubic information from any governmental authority.

5) Aiding and abetting: There should be legislation to expand the authority of the SEC to bring actions for aiding and abetting under each of the statutes it administers.