Introduction
The U.S. Securities and Exchange Commission (SEC) recently settled an enforcement action1 against an investment adviser to certain hedge funds, in which the adviser admitted to violations of federal securities laws and paid a $4.25 million penalty, as well as additional disgorgement of $243,427.2 Funds should view this case as a message from the SEC to advisers of hedge funds that they need to have processes and procedures in place designed to ensure:
Below is a summary of the facts and applicable regulations involved with respect to the SEC settlement, as well as key takeaways for managers to consider on a going-forward basis.
Background on Regulation SHO
Rule 200(a) of Regulation SHO generally defines a “short sale” to mean any sale of a security which the seller does not own or which is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 200(c) further provides that a person (including both natural and legal persons) shall be deemed to own a security only to the extent that the person has a net long position in such security. Consistent with these provisions, the SEC has repeatedly taken the position that a seller must aggregate its various long and short positions across all accounts in order to determine whether the seller has a net long or short position in the subject security. If a person has a net position in a security that is less than the quantity of shares that person seeks to sell, then such sale is deemed to be a “short sale” subject to certain rules governing short sales, including, but not necessarily limited to, the “locate” requirement of Rule 203(b)(1) of Regulation SHO,3 and the “uptick rule” of Rule 201 of Regulation SHO.4
While the term “seller,” as used in Rule 200, should generally be construed to mean a single person or legal entity, the SEC staff has historically taken a broad view to the extent the particular facts and circumstances indicate that two or more separate legal persons/entities are (i) effectively acting as one and the same organization (for example, through coordinated trading strategies or are structured to have substantially overlapping beneficial ownership); or (ii) otherwise act together to circumvent short sale regulations.
Rule 200(g) imposes upon broker-dealers the requirement to mark all sell orders of any security as “long” or “short.” An order can only be marked “long” if the seller owns the security being sold, and the security is either in the physical possession or control of the broker-dealer, or it is reasonably expected that the security will be in the physical possession or control of the broker-dealer prior to the settlement date of the transaction. If the seller does not own the security being sold, or owns the security being sold but does not believe it will be in the physical possession or control of the broker-dealer prior to settlement, the sale must be marked “short.”
Although the order marking requirements of Rule 200(g) apply to broker-dealers and not their customers, SEC Rule 10b-21 states that it shall be a “manipulative or deceptive device or contrivance” for any person to submit an order to sell an equity security if such person deceives a broker-dealer, a participant of a registered clearing agency (e.g., clearing/prime broker), or a purchaser about its intention or ability to deliver the security on or before the settlement date. More specifically, the SEC has indicated that a violation of Rule 10b-21 could occur where: (i) a short seller misrepresents to an executing broker that a “locate” has been obtained from a specific source (who did not actually provide a locate); or (ii) a seller misrepresents to an executing broker that they are “long” the securities being sold (but actually do not own the shares being sold) and (iii) the seller fails to deliver the securities sold on settlement date. As illustrated in the OZ Matter, Funds can also be charged with causing violations of Regulation SHO marking requirements by the broker-dealer.
Background on Rule 105 of Regulation M
In general, Rule 105 of Regulation M (the Rule) is directed at persons who sell short a security prior to an offering because they have a high likelihood of receiving discounted offering shares. Rule 105 generally prohibits any person (natural or legal person, including an investment fund) from purchasing securities obtained from an underwriter or other distribution participant that participates in a registered public offering of such securities for cash if such person effected a short sale within the Rule’s “Restricted Period” immediately prior to the pricing of the offering. The Restricted Period is the shorter of the following: (i) the five business days prior to pricing of an offering through the time of pricing of the offering; or (ii) the time period commencing with the initial filing of the registration statement (registered offerings) or notification on Form 1-A (Regulation A offerings) or 1-E (Regulation E offerings) through the time of pricing of the offering. In accordance with Rule 100 of Regulation M, the definition of “business day” means “a 24 hour period determined with reference to the principal market for the securities to be distributed, and that includes a complete trading session for that market.”
Rule 105 applies only to offerings that meet all of the following criteria: (i) the securities being offered are equity securities; (ii) the offering is conducted on a firm-commitment underwritten basis; and (iii) the offering is either (a) a SEC registered offering for cash or (b) a Regulation A or E offering for cash. There are three exceptions to the Rule’s general prohibition: (i) the bona fide purchase exception; (ii) the separate accounts exception; and (iii) the investment company exception.
SEC Settlement With OZ Management
The SEC entered into a settled enforcement action with OZ Management, LP (OZ) in which OZ admitted wrongdoing and agreed to pay a $4.25 million penalty, as well as disgorgement of $243,427, to settle the charges. According to the SEC’s Order, over a six-year period, OZ misidentified certain trades in data provided to four of its six prime brokers, which caused these prime brokers to inaccurately reflect long sales as short sales in their own books and records, and also caused the prime brokers to submit inaccurate “blue sheet” records to regulators. OZ did correctly mark its orders when transmitting them for execution, but at times the subsequent files OZ sent to its prime brokers reflecting its trades contained discrepancies versus the orders as sent to the market. The discrepancy arose for trades where OZ did not characterize sales as “long’ or “short” to prime brokers based on how they were marked when they were sent to the market, but rather filtered them based on other factors, such as the relevant fund’s position in the stock at the prime broker. As a result, the way trades were identified sometimes changed, causing some long sales to be erroneously shown as short sales when OZ provided the data to its prime brokers. The SEC said that these errors impacted their regulatory investigations, including reviews conducted of OZ for compliance with Rule 105 of Regulation M.
More specifically, in certain instances OZ traders marked sell orders as “long” or “short,” based on the relevant OZ fund’s global net position in the security. These orders were captured in OZ’s order management system, EZE Castle, and executing brokers placed the orders in the market for execution based on OZ’s “accurate trade type designations.” OZ exported the trading data in EZE Castle on a daily basis to OZ’s in-house accounting software platform, which at the close of trading each day generated an electronic trade file sent to the prime brokers where the funds maintained accounts and where the trades would settle. These trade files could be produced to prime brokers in two different “views”: (i) the “fund view,” which displayed sales as long or short based on the relevant fund’s position in the security firmwide; or (ii) the “prime broker view,” which displayed sales as long or short based on the relevant fund’s position in the stock at the prime broker where the trade was sent for settlement and not based on how the sale was marked at the executing broker. Consequently, situations arose where OZ submitted “long” sales to executing brokers, but the fund’s account at the prime broker did not hold sufficient shares to settle the trade, and thus the “prime broker view” trade file identified the long sale as a short sale, and the prime broker’s books and records and blue sheet reports incorrectly identified the sale as “short.”
Similarly, OZ assigned strategy codes to trades for internal purposes to track the performance of its trading strategies—the use of these strategy codes as one of the data filters (the strategy filter) when generating the “prime broker view” also altered the way the trade type was identified in the trade files provided to the prime broker. For example, when the relevant fund had a long position in a security and also at the prime broker, and thus a “long” sale was executed by the executing broker, but the particular strategy in that fund at the prime broker had no position, the OZ strategy filter switched the “long” sale to a “short” sale in the trade file. Importantly, where OZ identified sales as “long” with the executing broker, it was both: (i) net long and (ii) arranged for a long position that it held in such shares prior to sale to be delivered to the prime broker(s) to whom the trade was allocated, in order to settle the trade. As discussed above, if OZ had not taken such steps to deliver such long position to the prime broker(s) to whom it allocated the trade, then it would have been required to identify such sales as “short” with the executing broker.
Separately, OZ violated Rule 105, in that it effected short sales during the “restricted period” prior to the pricing of one public secondary offering, and then purchased securities in the offering. The SEC noted in the settlement that OZ did not recognize that its purchases were prohibited because a compliance associate miscalculated the Rule 105 restricted period.
Key Takeaways
The SEC settlement against OZ was clearly intended by the SEC to be a “shot across the bow” of advisers to hedge funds, and it can be anticipated that SEC examiners and enforcement attorneys will be asking advisers about the steps they take to address the types of issues identified in the settlement. Advisers should make any necessary adjustments to their processes and procedures to ensure:
The U.S. Securities and Exchange Commission (SEC) recently settled an enforcement action1 against an investment adviser to certain hedge funds, in which the adviser admitted to violations of federal securities laws and paid a $4.25 million penalty, as well as additional disgorgement of $243,427.2 Funds should view this case as a message from the SEC to advisers of hedge funds that they need to have processes and procedures in place designed to ensure:
- Orders to sell securities are properly identified to executing brokers as “long” or “short” in accordance with Regulation SHO.
- Consistent information concerning such orders is provided to both executing brokers and prime brokers.
- Compliance with Rule 105 of Regulation M, governing short selling prior to registered offerings of securities.
Below is a summary of the facts and applicable regulations involved with respect to the SEC settlement, as well as key takeaways for managers to consider on a going-forward basis.
Background on Regulation SHO
Rule 200(a) of Regulation SHO generally defines a “short sale” to mean any sale of a security which the seller does not own or which is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 200(c) further provides that a person (including both natural and legal persons) shall be deemed to own a security only to the extent that the person has a net long position in such security. Consistent with these provisions, the SEC has repeatedly taken the position that a seller must aggregate its various long and short positions across all accounts in order to determine whether the seller has a net long or short position in the subject security. If a person has a net position in a security that is less than the quantity of shares that person seeks to sell, then such sale is deemed to be a “short sale” subject to certain rules governing short sales, including, but not necessarily limited to, the “locate” requirement of Rule 203(b)(1) of Regulation SHO,3 and the “uptick rule” of Rule 201 of Regulation SHO.4
While the term “seller,” as used in Rule 200, should generally be construed to mean a single person or legal entity, the SEC staff has historically taken a broad view to the extent the particular facts and circumstances indicate that two or more separate legal persons/entities are (i) effectively acting as one and the same organization (for example, through coordinated trading strategies or are structured to have substantially overlapping beneficial ownership); or (ii) otherwise act together to circumvent short sale regulations.
Rule 200(g) imposes upon broker-dealers the requirement to mark all sell orders of any security as “long” or “short.” An order can only be marked “long” if the seller owns the security being sold, and the security is either in the physical possession or control of the broker-dealer, or it is reasonably expected that the security will be in the physical possession or control of the broker-dealer prior to the settlement date of the transaction. If the seller does not own the security being sold, or owns the security being sold but does not believe it will be in the physical possession or control of the broker-dealer prior to settlement, the sale must be marked “short.”
Although the order marking requirements of Rule 200(g) apply to broker-dealers and not their customers, SEC Rule 10b-21 states that it shall be a “manipulative or deceptive device or contrivance” for any person to submit an order to sell an equity security if such person deceives a broker-dealer, a participant of a registered clearing agency (e.g., clearing/prime broker), or a purchaser about its intention or ability to deliver the security on or before the settlement date. More specifically, the SEC has indicated that a violation of Rule 10b-21 could occur where: (i) a short seller misrepresents to an executing broker that a “locate” has been obtained from a specific source (who did not actually provide a locate); or (ii) a seller misrepresents to an executing broker that they are “long” the securities being sold (but actually do not own the shares being sold) and (iii) the seller fails to deliver the securities sold on settlement date. As illustrated in the OZ Matter, Funds can also be charged with causing violations of Regulation SHO marking requirements by the broker-dealer.
Background on Rule 105 of Regulation M
In general, Rule 105 of Regulation M (the Rule) is directed at persons who sell short a security prior to an offering because they have a high likelihood of receiving discounted offering shares. Rule 105 generally prohibits any person (natural or legal person, including an investment fund) from purchasing securities obtained from an underwriter or other distribution participant that participates in a registered public offering of such securities for cash if such person effected a short sale within the Rule’s “Restricted Period” immediately prior to the pricing of the offering. The Restricted Period is the shorter of the following: (i) the five business days prior to pricing of an offering through the time of pricing of the offering; or (ii) the time period commencing with the initial filing of the registration statement (registered offerings) or notification on Form 1-A (Regulation A offerings) or 1-E (Regulation E offerings) through the time of pricing of the offering. In accordance with Rule 100 of Regulation M, the definition of “business day” means “a 24 hour period determined with reference to the principal market for the securities to be distributed, and that includes a complete trading session for that market.”
Rule 105 applies only to offerings that meet all of the following criteria: (i) the securities being offered are equity securities; (ii) the offering is conducted on a firm-commitment underwritten basis; and (iii) the offering is either (a) a SEC registered offering for cash or (b) a Regulation A or E offering for cash. There are three exceptions to the Rule’s general prohibition: (i) the bona fide purchase exception; (ii) the separate accounts exception; and (iii) the investment company exception.
SEC Settlement With OZ Management
The SEC entered into a settled enforcement action with OZ Management, LP (OZ) in which OZ admitted wrongdoing and agreed to pay a $4.25 million penalty, as well as disgorgement of $243,427, to settle the charges. According to the SEC’s Order, over a six-year period, OZ misidentified certain trades in data provided to four of its six prime brokers, which caused these prime brokers to inaccurately reflect long sales as short sales in their own books and records, and also caused the prime brokers to submit inaccurate “blue sheet” records to regulators. OZ did correctly mark its orders when transmitting them for execution, but at times the subsequent files OZ sent to its prime brokers reflecting its trades contained discrepancies versus the orders as sent to the market. The discrepancy arose for trades where OZ did not characterize sales as “long’ or “short” to prime brokers based on how they were marked when they were sent to the market, but rather filtered them based on other factors, such as the relevant fund’s position in the stock at the prime broker. As a result, the way trades were identified sometimes changed, causing some long sales to be erroneously shown as short sales when OZ provided the data to its prime brokers. The SEC said that these errors impacted their regulatory investigations, including reviews conducted of OZ for compliance with Rule 105 of Regulation M.
More specifically, in certain instances OZ traders marked sell orders as “long” or “short,” based on the relevant OZ fund’s global net position in the security. These orders were captured in OZ’s order management system, EZE Castle, and executing brokers placed the orders in the market for execution based on OZ’s “accurate trade type designations.” OZ exported the trading data in EZE Castle on a daily basis to OZ’s in-house accounting software platform, which at the close of trading each day generated an electronic trade file sent to the prime brokers where the funds maintained accounts and where the trades would settle. These trade files could be produced to prime brokers in two different “views”: (i) the “fund view,” which displayed sales as long or short based on the relevant fund’s position in the security firmwide; or (ii) the “prime broker view,” which displayed sales as long or short based on the relevant fund’s position in the stock at the prime broker where the trade was sent for settlement and not based on how the sale was marked at the executing broker. Consequently, situations arose where OZ submitted “long” sales to executing brokers, but the fund’s account at the prime broker did not hold sufficient shares to settle the trade, and thus the “prime broker view” trade file identified the long sale as a short sale, and the prime broker’s books and records and blue sheet reports incorrectly identified the sale as “short.”
Similarly, OZ assigned strategy codes to trades for internal purposes to track the performance of its trading strategies—the use of these strategy codes as one of the data filters (the strategy filter) when generating the “prime broker view” also altered the way the trade type was identified in the trade files provided to the prime broker. For example, when the relevant fund had a long position in a security and also at the prime broker, and thus a “long” sale was executed by the executing broker, but the particular strategy in that fund at the prime broker had no position, the OZ strategy filter switched the “long” sale to a “short” sale in the trade file. Importantly, where OZ identified sales as “long” with the executing broker, it was both: (i) net long and (ii) arranged for a long position that it held in such shares prior to sale to be delivered to the prime broker(s) to whom the trade was allocated, in order to settle the trade. As discussed above, if OZ had not taken such steps to deliver such long position to the prime broker(s) to whom it allocated the trade, then it would have been required to identify such sales as “short” with the executing broker.
Separately, OZ violated Rule 105, in that it effected short sales during the “restricted period” prior to the pricing of one public secondary offering, and then purchased securities in the offering. The SEC noted in the settlement that OZ did not recognize that its purchases were prohibited because a compliance associate miscalculated the Rule 105 restricted period.
Key Takeaways
The SEC settlement against OZ was clearly intended by the SEC to be a “shot across the bow” of advisers to hedge funds, and it can be anticipated that SEC examiners and enforcement attorneys will be asking advisers about the steps they take to address the types of issues identified in the settlement. Advisers should make any necessary adjustments to their processes and procedures to ensure:
- Orders submitted to executing brokers are properly identified as “long” or “short,” in accordance with Regulation SHO.
- Orders may only be identified as “long” where there is a “net long” position in the security being sold and steps are taken to ensure that such long position is able to be delivered by the prime broker in order to settle the trade.
- Where there is not a net long position in the security being sold, however, there is a long position at the prime broker to whom a trade is allocated, such trade should be identified to both the executing broker and prime broker as a “short” sale. The prime broker and its customer may separately agree that the long position may be delivered to settle the trade.
- Compliance with Rule 105 of Regulation M, governing short selling prior to registered offerings of securities.
1 See In the Matter of OZ Management, LP, Exchange Act Release No. 75445 (July 14, 2015) (the OZ Matter).
2 The disgorgement related to one violation of Rule 105 of the SEC’s Regulation M.
3 Rule 203(b)(1) of Regulation SHO prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale order for the broker-dealer’s own account, unless the broker-dealer has: (i) borrowed the security or entered into an arrangement to borrow the security; or (ii) reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (iii) documented compliance with these requirements. See 17 CFR 242.203(b)(1). The broker-dealer must make and document the locate prior to effecting a short sale, regardless of whether the seller’s short position may be closed out by purchasing securities the same day.
4 Rule 201 of Regulation SHO, in general, applies to certain “Covered Securities,” defined as NMS stocks (e.g., exchange-traded stocks), that trip a “circuit breaker,” i.e., in the event that the intra-day price of the stock drops 10 percent from the stock’s close on the previous trading day. Once the circuit breaker is tripped, short sales in the Covered Securities will be prohibited at a price at or below the National Best Bid for the remainder of the day and the following day. See 17 CFR 242.201. See also Securities Exchange Act of 1934 Release No. 61595 (Feb. 26, 2010), 75 FR 11232 (Mar. 10, 2010).
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Securities & Derivatives Enforcement and Regulatory Practice
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