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SEC Proposes Amendments to Regulation M to Curb Abuses

The SEC has placed considerable focus on the initial public offering allocation and distribution process, according to Chairman William Donaldson. The result of that focus is proposed amendments to Regulation M, which was adopted in 1996 to address the activities of underwriters, issuers, selling security holders and others during an offering of securities. The proposed amendments, which were considered by the commissioners at yesterday's open meeting, are aimed at the misconduct that took place during the hot market for IPOs in the late 1990s, some of which has been the target of enforcement actions.

The amendments proposed by the Division of Market Regulation would lengthen the restricted period in which distribution participants must refrain from activities that could stimulate the market for the securities in distribution. The current restricted period for IPOs is five days. The proposed period would begin once the issuer reaches an understanding with the underwriter with respect to the distribution.

Another proposal would provide more transparency for syndicate activities that may influence the aftermarket price and trading of the offered securities by requiring that syndicate covering bids be publicly disclosed to the market. Underwriters use covering bids to purchase shares to cover their short positions. The proposed disclosure would resemble the disclosure currently required for stabilizing bids.

The SEC proposes to prohibit the use of penalty bids, which the staff believes can function as an undisclosed form of stabilization. A penalty bid lets the underwriter reclaim a selling concession from a syndicate member if the offered securities are immediately sold by an initial purchaser. The staff believes that penalty bids have been applied in a discriminatory fashion. Commissioner Roel Campos agreed that small investors are not on a level playing field and that penalty bids discriminate against retail investors.

The SEC's proposal would expressly prohibit IPO abuses such as tying arrangements in which customers agree to buy shares in the aftermarket or to buy shares in a less desirable offering in return for IPO allocations. The staff also discovered instances where customers agreed to pay excessive trading commissions on unrelated securities transactions in return for hot IPO allocations.

The proposed amendments would include a recordkeeping requirement for taking
advantage of the de minimis exception for inadvertent bids and purchases during the restricted period that total less than 2% of the distributed securities' average daily trading volume. The recordkeeping requirement will allow the staff to see how often distribution participants claim the de minimis exception. The proposal would also update the thresholds for the average daily trading volume and public float which are used to determine a security's restricted period and the availability of the exception for actively-traded securities. The thresholds would be determined under the proposal based on the Consumer Price Index .

Commissioner Cynthia Glassman said she supports the concept of the proposal, she said, but wants to ensure that it does not restrict the ability of underwriters to allocate shares to large, valued customers. Commissioner Paul Atkins also was concerned about the broad language in the proposal relating to inducements to purchase securities in the aftermarket. Associate Director Larry Bergmann said that proposed rule 106 is intended to address demands for additional consideration in order to get in on a deal. Atkins suggested that the staff provide guidance on legitimate customer relationships and the type of abuse it is trying to remedy. Bergmann said the rule is not attempting to address a customer who sends a lot of order flow to a firm and receives preferential allocations. It is intended to address situations such as kick-backs of a portion of the profits in the allocation in return for getting in on the deal. He agreed the distinction can be a fine line.

The commissioners unanimously approved the issuance of the proposal for comments. The comment period will be open for 60 days.