SEC Issues Release Detailing Amendments to Rule 105 of Regulation M

On August 6, 2007, the Securities and Exchange Commission (the “Commission”) issued a release detailing the amendments previously adopted by the Commission at its Open Meeting held June 20, 2007 with respect to Rule 105 of Regulation M (see Release 34-56206, the “Release”). The amendments will be effective October 9, 2007.

Subject to limited exceptions, Rule 105 currently prohibits a person from covering a short sale with offered securities purchased from an underwriter or broker-dealer participating in a firm commitment offering of securities for cash pursuant to a registration statement or notification on Form 1-A (and, post-amendment, Form 1-E), if the short sale occurred during the period ending with the pricing of the offering and beginning on the later of (1) the fifth business day before pricing, or (2) the initial filing of the registration statement or notification (the “pre-pricing period”). The amendments to Rule 105 eliminate the “covering” component of the current prohibition and make it unlawful for a person who sold short during the pre-pricing period to purchase securities in the offering -- even if the securities purchased in the offering are not used to cover the short sale -- unless an exception is available. According to statements made by Commission staff at the Open Meeting, the new “bright-line” rule is intended to put an end to the progression of schemes that have been engineered to camouflage covering activity that is already prohibited by Rule 105, to streamline compliance with Rule 105 and to facilitate enforcement of Rule 105.

The amendments incorporate certain new exceptions from Rule 105’s purchase prohibition:

(i)      Bona fide Pre-Pricing Covering Purchases. Rule 105, as amended, will incorporate an exception allowing the purchase of securities in the offering by persons who established short positions in the offered securities during the pre-pricing period but then entered a bona fide transaction that closed out those short positions prior to the pricing of the offering. To be eligible for the exception, the covering transaction will be subject to certain conditions intended to assure transparency, provide time for the effects of the pre-pricing period short sale to dissipate and provide an opportunity for the market to react to the covering purchase. This exception is intended to provide an opportunity for persons to participate in the offering if they sold short before becoming aware of the offering or as a part of normal trading strategies. However, in order to rely on this exception, the covering pre-pricing purchase must be effected at least one business day prior to the pricing of the offering. Accordingly, as expressly acknowledged in the Release, this exception will not allow participation in a true “overnight” deal by a prospective purchaser (presumably, unless it can meet the criteria for the “separate accounts” exception discussed below) that has engaged in pre-pricing period short sales because such person will not have time to effect a good covering purchase prior to the pricing date for the offering. The exception also requires that the pre-pricing covering purchase be in an amount at least equal to the amount of the pre-pricing period short sale, be effected during regular trading hours and be reported pursuant to an effective transaction reporting plan. Finally, a person relying on this exception may not effect a pre-pricing period short sale within the 30 minutes prior to the close of regular trading on the business day prior to the pricing date of the offering. The Commission believes these conditions will (1) alleviate downward pressure resulting from the short sale activity with the offsetting upward pressure of the covering purchase, (2) help ensure that the covering purchase was a bona fide purchase effected for the legitimate purpose of closing out the short sale position, (3) afford transparency and allow the market an opportunity to react to the covering purchase, as well as the pre-pricing period short sale, prior to the pricing of the offering, and (4) protect against potentially manipulative trading activity near the close of trading prior to pricing that could lower the offering price and thereby reduce the proceeds to the issuer or selling shareholder resulting from the offering.

(ii)       Purchases by Independent Trading Units and Other Separate Accounts. Amended Rule 105 contains an exception for certain types of accounts that are related, but that are separately managed and do not engage in coordinated trading activity (the “Separate Accounts Exception”). The Separate Accounts Exception incorporates and builds on the “aggregation unit” concept found in Rule 200(f) of Regulation SHO. However, the Separate Accounts Exception is available to any entity that satisfies the exception’s requirements and, in that regard, is more expansive and flexible than the Regulation SHO aggregation unit provision, which by its terms is available only to broker-dealers. In particular, this exception allows a person (whether a broker-dealer, investment adviser, individual investor or other entity) to purchase offered securities in an “account” even if there was a short sale of the offered securities during the pre-pricing period in a related, but separately managed, account, provided investment decisions for the related accounts are made independently and without coordination among the traders or managers or trading among or between the accounts. The Release notes that the term “accounts” for purposes of this exception is used as a general term that may encompass many different structures, including portions of a particular fund, segregated business units and separately identifiable divisions or departments within a single legal vehicle (see Release, note 64). According to the criteria set forth in the Release, accounts that have separate and distinct investment and trading strategies and personnel, do not coordinate trading activity, and do not communicate securities positions, investment decisions, or other trading information between the accounts, should be deemed “separate” for purposes of the Rule. The Release contains guidance as to when accounts will be deemed “separate” for purposes of the Separate Accounts Exception, but the Commission notes that the “separateness factors” identified in the Release are intended to be illustrative only and not exhaustive.

(iii)       Purchases by Investment Companies. Amended Rule 105 also contains an exception specifically applicable to investment companies registered under Section 8 of the Investment Company Act of 1940. This new exception allows a registered investment company to purchase securities in the offering even if an affiliated investment company (or another fund in the same fund family or fund series) sold the offered security short during the pre-pricing period.

Other Amendments and Clarifications to Rule 105.

Equity Offerings. The amendments to Rule 105 make clear that the Rule’s prohibitions apply only to offerings of equity securities for cash. The Release notes, however, that the Commission will continue to monitor debt offerings to assess whether trading patterns in debt securities raise manipulation concerns and thus warrant extension of the Rule to debt offerings.

Subject Securities. The Release clarifies that the amended Rule’s reference to the “security that is the subject of the offering” is intended to be synonymous with the definition of “subject security” in Rule 100 of Regulation M. Accordingly, the amended Rule does not prohibit a person that shorted common stock in the pre-pricing period from purchasing securities that are convertible into or exchangeable for such common stock. However, the Release notes that the Commission will continue to monitor the convertible offering market and “may re-evaluate these offerings” in the future.

Purchase. For purposes of Rule 105, the definition of “purchase” includes a contract for sale. Accordingly, the time of the “purchase” is the “time the investor becomes committed by agreement or is committed to buy the offered securities, whether such agreement is oral or written” (see Release, note 88 and accompanying text).

Derivatives. Although the Release notes that the Commission will continue to monitor the use of derivative strategies, including (among other things) the extent to which such strategies are the functional equivalent of equity trading covered by the Rule, the Commission chose not to amend Rule 105 to address derivative trading strategies at the present time. The Release contains a reminder, however, that even transactions or series of transactions that do not violate Rule 105 remain subject to the general anti-fraud and anti-manipulation provisions of the securities laws.

Regulation E. The amendments to Rule 105 also encompass offerings made pursuant to Form 1-E under Regulation E (which is available for offerings of securities by registered small business investment companies that have elected to be regulated as business development companies pursuant to Section 54(a) of the Investment Company Act of 1940).

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The Release is available at http://www.sec.gov/rules/final/2007/34-56206.pdf.

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CLEARY GOTTLIEB STEEN & HAMILTON LLP