Wednesday, March 29, 2017

Morrison precludes application of Rule 105 to purchase after short sale

By Rodney F. Tonkovic, J.D.

In a question of first impression, the district court sitting in Manhattan has applied Morrison's extraterritoriality analysis to Rule 105 of Regulation M. At minimum, the court concluded a purchase must satisfy Morrison for Rule 105 to apply. The transactions at issue in this case were not subject to Rule 105 because while the short sales took place on the NYSE, the activities related to the subsequent purchase of the same securities in an offering occurred entirely outside of the United States (SEC v. Revelation Capital Management, Ltd., March 27, 2017, Caproni, V.).

Short sales. Hedge fund manager Revelation Capital Management, Ltd. (Revelation), and its founder, Christopher Kuchanny, are located in Bermuda. In November 2009, Revelation sold short approximately 1.3 million shares of Central Fund, a Canadian investment holding company on the NYSE. The short sales were executed through a brokerage account in New York and cleared and settled through another account in London.

Soon after, Central Fund announced a proposed underwritten offering. After being contacted by a representative of the underwriter, Kuchanny agreed to buy approximately 4 million shares. The offering closed on November 17, 2009, and the shares issued pursuant to the offering were issued to the Central Depository for Securities in Canada. The proceeds of the purchases were wired to the underwriter in Canada and then to Central Fund. The offering was registered with the Canadian regulatory authority and cross-registered with the SEC.

The Commission alleged that Revelation violated Rule 105 of Regulation M. According to the Commission, Revelation violated Rule 105 by purchasing shares in the offering after having sold short the same securities during the restricted period. Revelation countered that Rule 105 did not apply to the transactions under Morrison v. National Australia Bank Ltd.

Precluded by Morrison. The court concluded that at a minimum, a purchase must satisfy Morrison for Rule 105 to apply, and that Revelation's transactions were not subject to Rule 105. At issue was whether the transactions were "domestic," and the court noted that the application of Morrison's extraterritoriality analysis to Rule 105 was a question of first impression. The court observed further that, unlike Section 10(b), Rule 105 involves two transactional events: selling short a security and subsequently purchasing the same security in an offering.

There was no dispute that prior to the offering, Revelation sold short Central Fund shares on the NYSE through broker in New York. The subsequent activities related to the offering, however, were entirely foreign, and none of the record evidence, the court said, showed that Revelation incurred irrevocable liability within the United States for their purchase of the offering shares. The negotiations and agreement to purchase took place over the telephone from the parties' respective locations in Bermuda and Canada, and the offering itself was negotiated and signed in Canada. The SEC similarly failed to adduce any evidence showing that title for the offering shares passed within the U.S. Accordingly, Revelation's purchase failed both prongs of Morrison, the court determined.

The Commission maintained that Revelation's short sales on the NYSE were sufficient to satisfy Morrison, but the court was not persuaded. In this case, the short selling was a wholly separate and distinct event from Revelation's purchase in the offering, the court explained. To interpret the short sale as "in connection with" the purchase in the offering was overly expansive and inconsistent with the presumption against extraterritoriality, the court said.

In conclusion, the court said that the SEC release regarding Rule 105 makes it clear that the prohibited activity is purchasing in the offering. Since the purchase in this case was neither a transaction in a security listed on a domestic exchange nor a domestic transaction in an unlisted security, Rule 105 was not applicable to the transactions in this case, the court found.

The case is No. 14-CV-645.

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