SEC Regulation M

Regulation M is a set of rules created by the SEC to prevent price manipulation during securities offerings. These rules apply when companies or other parties are selling securities to the public. The regulation creates specific restrictions on trading activities that could artificially inflate or manipulate a security's price during the offering process.

For hedge funds, Regulation M becomes important when they participate in secondary offeringsPublic sales of securities by existing shareholders or the company after the initial public offering, often subject to specific regulatory restrictions., SPAC transactionsTransactions involving Special Purpose Acquisition Companies that raise capital through public offerings to acquire operating businesses., or other distribution activities. This is especially true when a hedge fund might play multiple roles in a transaction or have conflicting interests.

The regulation prohibits certain parties from buying, bidding for, or encouraging others to buy securities during specific "restricted periods." These parties include the company issuing the securities, existing shareholders who are selling shares, and other participants in the distribution process.

The goal is to prevent artificial price support during the offering. Without these rules, participants could manipulate the market price to make their offering more attractive or profitable.

The length of the restricted period depends on several factors. For securities with higher trading volumes and larger public floatsThe portion of a company's shares that are available for trading by the general public, excluding restricted shares held by insiders., the restricted period typically begins one business day before pricing. For securities with lower volumes or smaller public floats, the restricted period starts five business days before pricing.

Rule 105 is a particularly important part of Regulation M that focuses on short selling Short selling Short selling is an investment strategy where a hedge fund borrows securities and sells them with the expectation of repurchasing them at a lower price in the future, profiting from price declines while incurring the obligation to return the borrowed securities. . This rule prohibits a specific manipulative strategy where someone might short sell a security during the restricted period and then purchase shares in the offering to cover their short positionAn investment position where an investor has sold borrowed securities with the expectation that the price will decline, allowing them to buy back at a lower price..

Here's why this matters: without Rule 105, someone could artificially depress a security's price by short selling it right before or during an offering. Then, they could cover their short position by buying shares at the lower offering priceThe price at which securities are sold to investors in a public or private offering, typically set during the pricing process.. This would give them an unfair profit while manipulating the market.

When the SEC discovers Rule 105 violations, they can impose both civil and criminal penalties. These penalties often include monetary fines and requiring violators to give up any profits they made from the prohibited conduct. The SEC typically calculates penalties based on the economic benefit gained from the manipulation, often focusing on the price difference between the market price and offering price multiplied by the number of shares involved.

Hedge funds must be especially careful when they have positions in securities that are subject to Regulation M restrictions. This becomes complex when funds deal with convertible securitiesFinancial instruments that can be converted into another form of security, typically bonds or preferred shares that can be converted into common stock., derivativesFinancial instruments whose value is derived from underlying assets, including options, futures, swaps, and forwards., or when they serve as both an investor and a participant in the distribution process.

Successful compliance requires close coordination between a fund's trading desk and compliance team. They must ensure that all trading activities follow the restricted period limitations. Even accidental violations can result in significant regulatory penalties and damage to the fund's reputation.

Hedge funds should establish clear procedures for identifying when securities in their portfolios become subject to Regulation M restrictions. They should also implement systems to prevent inadvertent trading violations during restricted periods.