News

Interpretive Release Under Reg M with Respect to IPO Allocations

News Brief
April 8, 2005

By: Cydney Posner

Yesterday, the SEC posted an interpretive release under Reg M with respect to prohibited conduct in connection with IPO allocations.  The release is designed to provide guidance with respect to the book-building process, particularly in connection with the allocation of shares in IPOs, and to highlight prohibited activities that underwriters should avoid during restricted periods. The line between acceptable and prohibited conduct is a fine one, and much of the guidance is rather nuanced and aimed at the implications of certain communications that may violate the Reg. Whether conduct violates Reg M depends on all the facts and circumstances, including past course of dealing, the nature of the customer, timing, the nature of the communication and other factors.

Reg M

Reg M precludes activities that could artificially influence the market for an offered security. Rule 1017 makes it unlawful for any distribution participant or its affiliated purchasers, "directly or indirectly, to bid for, purchase, or attempt to induce any person to bid for or purchase, a covered security" during the distribution’s restricted period. The SEC is concerned that this type of activity could undermine the integrity of the market by affecting its independent pricing mechanisms. Reg M addresses direct and indirect market activity by distribution participants and conduct by distribution participants "that causes or is likely to cause another person to bid for or purchase covered securities." Reg M applies to "attempts," proscribing conduct regardless of whether it actually results in market activity by others. The induced activity (i.e., aftermarket bids or purchases) may occur during or after the restricted period or not at all. "Inducement to purchase" broadly refers to "activity that causes or is likely to cause another person to bid for or purchase covered securities." Whether particular conduct is prohibited depends upon all of the facts and circumstances; however, no proof of intent is required.

Book-Building

Book-building, the process by which underwriters gather and assess potential investor demand for an offering, helps the underwriters determine the size and price of the deal. Most of the information-gathering process is not viewed as problematic, including questions such as the customer’s evaluation of the issuer’s products, earnings, history, management and prospects, valuation of the securities being offered, amount sought to be purchased at various price levels, current ownership of similar securities, prices at which the customer expects the shares will be trading three to six months after the offering, whether the customer intends to be a long-term holder or to flip the shares, desired long-term future position in the security or industry and the prices at which the customer might accumulate that position. The SEC emphasizes, however, that there is no "book-building exception" to Reg M. Although an underwriter's efforts to obtain information about demand for an offering during the book-building process would not, by itself, constitute an inducement or attempt to induce," the SEC cautions that "accompanying conduct or communications...may cause the collection of information to be part of conduct that violates Regulation M. Underwriters and other distribution participants must take care that their activities do not cross the line into prohibited attempts to induce aftermarket bids or purchases by prospective investors or others. The determination as to whether an activity or communication constitutes legitimate book-building or an attempt to induce a bid or purchase in violation of Regulation M depends on the particular facts and circumstances surrounding such activity or communication."

Prohibited Conduct

The SEC has determined that the following activities and conduct during the restricted period violate Reg M:

  • Inducements to purchase in the form of tie-in agreements or other solicitations of aftermarket bids or purchases prior to the completion of the distribution.
  • Communicating to customers that expressing aftermarket interest or immediate aftermarket buying would help them obtain allocations of hot IPOs.The SEC views this communication as clearly aimed at inducing customers to bid for or purchase securities in the immediate aftermarket in return for an allocation. However, the SEC does not view inquiring as to customers’ desired future position in the longer term (for example, three to six months) and the prices at which customers might accumulate that position, by itself and without reference to immediate aftermarket activity, to be problematic conduct.
  • Soliciting customers, prior to the completion of the distribution, regarding whether and at what price and in what quantity they intend to place immediate aftermarket orders for IPO stock. Where the sales representative inquires about the customer's intent to place orders in the immediate aftermarket, and if so, at what prices and quantities, the SEC believes that the clear expectation is that the customer will submit aftermarket orders at the prices and quantities discussed if the customer receives an allocation of shares. However, inquiring as to a customer’s desired future position in the longer term (for example, three to six months), and the prices at which the customer might accumulate that position, without reference to immediate aftermarket activity, would not, without more, be a violation. The SEC also views solicitation of aftermarket interest from customers that the underwriter knows, or should know, are not long-term holders of IPO stock may be an indication of an attempt to induce aftermarket activity.
  • Proposing aftermarket prices to customers or encouraging customers who provide aftermarket interest to increase the prices at which they are willing to place orders in the immediate aftermarket. The SEC considers encouraging customers to increase aftermarket prices to convey that bidding in the immediate aftermarket at higher price levels is expected as consideration for an allocation or an improved allocation in the IPO. Communication to customers about valuation or offering price information from third parties is not violative so long as it would not be likely to cause the customer to express an interest in paying a higher price in the immediate aftermarket; however, communicating third party information could be a violation if it encourages an increase in prices, for example, by communication of prices of aftermarket interest of third parties so as to improperly convey to a customer that a commitment in the aftermarket at higher price levels is expected.
  • Accepting or seeking expressions of interest from customers that they intend to purchase an amount of shares in the aftermarket equal to the size of their IPO allocation ("1 for 1") or intend to bid for or purchase specific amounts of shares in the aftermarket that are pegged to the allocation amount without any reference to a fixed total position size. By seeking this type of aftermarket interest from customers, the SEC considers the underwriter to be attempting to induce customers to place orders or buy in the aftermarket. Customers may, however, express a desire to purchase in the aftermarket without prompting, where the customer’s statement is spontaneous, unless a prior course of dealing suggests otherwise. In any event, a sales representative's acceptance of a customer’s offer to purchase shares in the immediate aftermarket that is expressly linked to the receipt of an allocation is a prohibited tie-in agreement and violates Reg M.
  • Soliciting aftermarket orders from customers before all IPO shares are distributed or rewarding customers for aftermarket orders by allocating additional IPO shares to such customers. By soliciting orders or rewarding customers who place orders in the immediate aftermarket with additional IPO shares in the same offering, the underwriter is improperly stimulating aftermarket purchases during the restricted period (prior to completion of the distribution of all of the IPO shares).
  • Communicating to customers in connection with one offering that expressing an interest in the aftermarket or buying in the aftermarket would help them obtain IPO allocations of other hot IPOs.Brokers are not permitted to attempt to induce aftermarket bids or purchases by linking them to the customer’s desire to receive allocations in future hot IPOs. This conduct may be distinguished, however, from mere communications to determine if a customer is a long-term investor in one or more other issuers, whether or not a customer engages in aftermarket bids or purchases.
In addition, the SEC views certain conduct after the restricted period, while not illegal in itself, to be evidence that an underwriter attempted during the restricted period to induce customers to bid for or purchase stock in the aftermarket. Examples of this type of activity include:

  • follow-up solicitations for immediate aftermarket orders from customers that had provided aftermarket interest earlier; and
  • tracking or monitoring customers’ aftermarket purchases to see whether they had followed through on their aftermarket interest.
Although there are legitimate reasons to monitor customer activity, the SEC would be suspicious of tracking customers’ aftermarket purchases in the first few days of trading following an IPO.

The SEC advocates that underwriters implement effective policies and procedures to detect and prevent prohibited solicitations, tie-in agreements and other attempts to induce aftermarket bids or purchases during the restricted period. These policies should, at a minimum, prohibit and monitor the activities discussed above, provide for corrective action and include procedures and systems to supervise sales representatives and other firm employees to prevent and detect improper conduct.

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