Regulation M was adopted in 1996 to prevent manipulation of the price of an offered security by offering participants during an offering. Regulation M prohibits underwriters, broker-dealers, issuers (including selling security holders) and other persons participating in a "distribution" from directly or indirectly bidding for or purchasing the offered security (or inducing another person to do so) during the applicable "restricted period."
Regulation M is organized into six rules:
- Rule 100, definitions;
- Rule 101, covering the activities of underwriters, broker-dealers and others participating in a distribution;
- Rule 102, governing activities by issuers and selling security holders during a distribution;
- Rule 103, Nasdaq passive market making;
- Rule 104, governing stabilization transactions and certain post-offering activities by underwriters; and
- Rule 105, governing short selling in anticipation of a public offering.8
This article addresses issues arising in the realm of Rules 101 and 102, and does not discuss activities affected by Rules 103-105.
SOME IMPORTANT DEFINITIONS
The "restricted period" under Regulation M means, for a security, the period beginning on the later of five business days prior to the pricing of the offered security or such time that a person becomes a distribution participant, and ending upon such person's completion of participation in the distribution. For any security with a worldwide average daily trading volume ("ADTV") (as defined) value of $100,000 or more of an issuer whose common equity securities have a public float of $25 million or more, the restricted period is the period beginning on the later of one business day prior to the determination of the offering price or such time that a person becomes a distribution participant, and ending upon such person's completion of participation in the distribution.
A "distribution" means an offering of securities, whether or not subject to registration under the Securities Act of 1933 (the "Securities Act"), that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods. Factors relevant to the "magnitude of the offering" include the number of shares to be offered for sale by the issuer and the percentage of the outstanding shares, public float and trading volume that those shares represent.9 Providing greater than normal sales compensation arrangements pertaining to the distribution, delivering a sales document, such as a prospectus, and conducting road shows are considered to be generally indicative of "special selling efforts and selling methods."10 Distributions may include public offerings, private placements such as Rule 506 offerings, shelf offerings, exempt offerings such as bank note programs, exchange offers, and private investment in public equities (PIPE) offerings.11
A "distribution participant" means an underwriter, prospective underwriter, broker, dealer, or other person who has agreed to participate or is participating in a distribution.
"Completion of participation in a distribution" occurs when a participant in the distribution acquires securities for investment. For an issuer, such completion occurs when the distribution is completed, meaning that the securities are all sold (this may include instances in which unsold allotments are taken into investment accounts) and the syndicate (assuming there was a syndicate in place in connection with the distribution) is terminated. For an underwriter, such completion occurs when the underwriter's participation has been distributed, including all other securities of the same class acquired in connection with the distribution, and any stabilization arrangements and trading restrictions in connection with the distribution have been terminated, subject to an exception discussed below.
A "covered security" means any security that is the subject of a distribution, or any reference security. A "reference security" means a security into which a security that is the subject of a distribution ("subject security") may be converted, exchanged, or exercised or which, under the terms of the subject security, may in whole or in significant part determine the value of a subject security.
WHAT ACTIVITIES ARE PROHIBITED?
Rule 101 covers the activities of underwriters and dealers. The rule provides that, in connection with a distribution of securities, it shall be unlawful for a distribution participant or an affiliated purchaser of such person, directly or indirectly, to bid for, purchase, or attempt to induce any person to bid for or purchase, a covered security during the applicable restricted period.
Rule 102 covers the activities of issuers and selling security holders. The rule provides that, in connection with a distribution of securities effected by or on behalf of an issuer or selling security holder, it shall be unlawful for such person, or any affiliated purchaser of such person, directly or indirectly, to bid for, purchase, or attempt to induce any person to bid for or purchase, a covered security during the applicable restricted period.
Each of Rule 101 and Rule 102 have a carveout, available depending on the role of the distribution participant. The proviso to Rule 101(a) provides that if a distribution participant or affiliated purchaser is the issuer or the selling security holder of the securities subject to the distribution, such person shall be subject to Rule 102 rather than Rule 101. The proviso to Rule 102(a) provides that if an affiliated purchaser is a distribution participant, the affiliated purchaser may comply with Rule 101 instead of Rule 102.
WHAT TYPES OF OFFERINGS AND ACTIVITIES ARE EXEMPT?
Both Rule 101 and Rule 102 have exceptions for certain securities and transactions. Under Rule 101, distribution participants and their affiliated purchasers are permitted to engage in the routine dissemination of research reports, the exercise of options and other securities, transactions in baskets of securities involving a covered security, and [certain] Rule 144A transactions.
Because issuers and selling security holders have the greatest interest in an offering's outcome, the transaction exceptions of Rule 102 are narrower than those of Rule 101. Rule 102 permits, during the restricted period, transactions in nonconvertible investment grade securities and, exercises of options and other securities, and odd-lot transactions and associated round-up transactions during an issuer odd-lot tender offer. Most transactions in connection with dividend reinvestment plans and stock purchase plans are excluded from Rule 102.
Both Rule 101 and 102 except the same securities from their coverage: (i) "actively-traded securities," those that have an ADTV value of at least $1 million and are issued by an issuer whose common equity securities have a public float of at least $150 million (other than the distribution participant or any of its affiliates); (ii) investment grade nonconvertible debt or preferred, and asset-backed, securities, rated investment grade by at least one rating agency;12 (iii) exempted securities, as defined in Section 3(a)(12) of the Securities Exchange Act of 1934 ("Exchange Act"); and (iv) face-amount certificates or securities issued by an open-end management investment company or unit investment trust.
FINRA NOTICE REQUIREMENTS
Under FINRA Rule 5190(c)(1), a member firm acting as a manager (or in a similar capacity) in a distribution of a covered security subject to a restricted period under Rule 101 must notify FINRA of its determination as to whether a one- or five-day restricted period applies under Rule 101 and the date and time of the commencement of the restricted period, the pricing of the distribution, the cancellation of any distribution for which prior notification of the commencement of the restricted period has been submitted to FINRA and other related information. If a member firm is acting as a manager (or in a similar capacity) of a distribution of an actively traded security, then, under FINRA Rule 5190(d), the member firm must notify FINRA that no restricted period applies under Rule 101 and the basis for such firm's determination. The member firm must also notify FINRA of the pricing of the distribution and other related data.
A structured note that derives its value from an underlying security, such as a share of common stock, would be a derivative security, not subject to Regulation M.13 The underlying share of common stock would be a reference security. A security will be a reference security only when it, or an index of which it is a component, is referred to in the terms of the subject security (the structured note).14 Consequently, during a distribution of a structured note, Rule 102 applies to the reference security. For structured notes linked to common stock, the ADTV exemption will most likely apply. Therefore, the issuer of the structured note can purchase or sell the underlying common stock during the distribution of the structured note, and also enter into derivative transactions on the underlying common stock.
Structured notes are generally sold on a riskless principal basis; i.e., the underwriter has customer orders in hand prior to purchasing the structured notes from the issuer to satisfy such orders. In the past, questions were raised about whether a distribution had been completed if an underwriter purchased securities for investment. When and how may an underwriter sell its unsold allotment? In order to avoid an inadvertent extension of the restricted period, practitioners have advised that the unsold allotment be held in the underwriter's investment account (the "freezer") for a significant period of time before any resale.
OVER-SELLING THE SHOE
An underwriter's participation in a distribution will not be deemed to be completed if a syndicate overallotment option is exercised in an amount that exceeds the net syndicate short position at the time of such exercise.15 This situation is more likely to occur in an equity offering, where a "green shoe" overallotment option is held by the underwriters. It may also occur in offerings of listed debt securities, such as "public income notes." If an overallotment option is exercised for an amount of securities that exceeds the syndicate net short position (i.e., taking into account shares purchased in stabilizing or syndicate short covering transactions), the distribution would be deemed to continue until the time that all the excess shares were sold, and purchases of the securities made prior to the exercise of the option would have been in violation of Regulation M.16
INVESTMENT GRADE NONCONVERTIBLE DEBT SECURITIES
The exemption from Rules 101 and 102 for investment grade nonconvertible debt securities provides is useful for dealers and issuers, respectively, of structured notes. This exemption is based on the premise that these securities are traded on the basis of their yields and credit ratings, are largely fungible and, therefore, are less likely to be subject to manipulation.17 Although not defined, the term "investment grade nonconvertible debt securities" is understood to mean debt securities of an issuer that are not convertible into any of the issuer's securities or exchangeable for securities of any other issuer. Many practitioners take the view that even if the offered security is not itself rated by a nationally recognized statistical rating organization, the offered security is within the exemption if it is pari passu, or in the same class or series, with other investment grade nonconvertible debt securities of the same issuer. This approach is used by market participants when market making in, or holding an inventory of, rate-linked notes of an issuer that are pari passu with that issuer's investment grade rated nonconvertible fixed rate debt securities.
EXCHANGE TRADED NOTES
Exchange traded notes ("ETNs") are continuously issued and offered in response to customer demand. Due to these ongoing ETN creations, the distribution is continuous, as is the restricted period. This raises an issue, as the ETN issuer needs to be able to redeem ETNs, and its affiliated broker-dealer needs to conduct marketmaking activities, during the restricted period. Without relief from the Staff, the redemptions and marketmaking activities would have violated Rules 102 and 101 of Regulation M, respectively. Consequently, prior to the time of the first ETN issuance, Barclays Bank plc requested no-action relief from the SEC Division of Trading and Markets.18
In the iPath Letter, counsel raised a number of points about the ETN mechanics, arguing that, taken together, issuer redemptions and purchases and sales by its affiliated dealer would not affect the market price of the ETNs:
- The NYSE listing would provide intra-day secondary market liquidity;
- The ETNs were redeemable by the holders on a weekly basis;19
- Arbitrage activity will remove any significant disparity between the market price of the ETNs and the value of their underlying index;
- Because the value of the ETNs would be tied primarily to the value of their underlying index, market-making activities by the broker-dealer would not have a significant impact on the trading price of the ETNs;
- The underlying index level was publicly available on a real-time basis; and
- The issuer would publish the ETNs' "indicative value," meant to approximate the economic value of the ETNs, on a public source, and calculate the end-of-day indicative value and publish it on the issuer's website.
The Staff granted relief based on the weekly redemption feature and that the secondary market price of the ETNS should not vary substantially from the value of the underlying index.
The SEC Division of Trading and Markets ("DTM") may have taken note of the rationale raised by counsel in the iPath Letter when considering whether participants in a distribution of actively–managed exchange-traded fund ("ETF") shares could bid or purchase such shares during a distribution under the Rule 101(c)(4) exemption and whether the Rule 102(d)(4) exception was available to permit an open-end investment company to redeem actively managed ETF shares. In responding affirmatively to these questions in Staff Legal Bulletin No. 9 (revised Nov. 22, 2019), the DTM essentially ticked off the points raised by counsel in the iPath Letter as conditions for meeting the exemptions.
8 17 CFR §§242.100-105.
9 See FINRA SEC Regulation M-Related Notice Requirements under FINRA Rules Frequently Asked Questions ("FINRA Reg M FAQ") Q2.2.
10 FINRA Reg M FAQ Q2.3.
11 FINRA Reg M FAQ Q1.1.
12 A "nationally recognized statistical rating organization" as defined in Section 3(a)(62) of the Exchange Act.
13 See Release No. 33-7375 (Dec. 20, 1996) (the "Adopting Release") at II.B.3.
15 See 17 CFR §242.100.
16 See the Release at II.B.2.c.
17 See the Release at II.b.6.b. In Release 34-64352 (Apr. 27, 2011), the SEC proposed removing the references to credit ratings in Rules 101 and 102, and replacing them with a set of standards.
18 Barclays Bank PLC (July 27, 2006) SEC no-action letter (the "iPath Letter").
19 Modern ETNs are redeemable on a daily basis.
Originally published in REVERSEinquiries: Volume 3, Issue
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