Hedge Fund Adviser and Associated Individuals Pay Over $8 Million to SEC for “Causing” Reg SHO and Dealer Registration Violations

Overview and Executive Summary

On August 17, 2021, the U.S. Securities and Exchange Commission (SEC) announced settled charges against an unregistered investment adviser to a hedge fund (Hedge Fund Adviser) and associated individuals for (i) causing broker-dealers with whom orders were placed to violate Regulation SHO (Reg SHO) and (ii) causing the hedge fund to violate the dealer registration provisions of the Securities Exchange Act of 1934, as amended (Exchange Act).¹ This enforcement action was in connection with the Hedge Fund Adviser causing the fund to enter into securities purchase agreements with multiple issuers whose stock was traded on the Nasdaq Stock Market, and is notable for several reasons:

• It is further evidence of the SEC’s continuing focus on Reg SHO, especially in the context of situations where hedge funds and other market participants are providing financing to issuers in return for receiving issuer stock at a discount to the market price therefor, and then engaging in sales of the issuer’s stock that could constitute a broad distribution thereof.²
• It is a reminder to hedge funds and other market participants that engaging in certain financings with issuers may require registration as a broker-dealer, both under the Exchange Act and applicable states’ “Blue Sky” or securities laws.
• It is an example of the potential punitive impacts associated with an SEC settlement – in addition to requiring the Hedge Fund Adviser and its associated individuals to pay over $8 million, the settlement order also imposes a two-year undertaking pursuant to which the Hedge Fund Adviser, when placing an order with a broker for the sale of securities purchased directly from an issuer, must provide the broker with a copy of the SEC Settlement Order against the Hedge Fund Adviser as well as a legal opinion that describes when the hedge fund is “deemed to own” the securities being sold “long” or “short exempt” and the documentation to establish that belief.

Reg SHO

Rule 200(a) of Reg SHO defines a “short sale” to mean any sale of a security that the seller does not own or that is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 200(b) of Reg SHO sets forth criteria for when a person is deemed to own a security, including if: (1) the person or his agent has title to the security; (2) the person has purchased, or has entered into an unconditional contract, binding on both parties thereto, to purchase, but has not yet received the security; (3) the person owns a convertible security that has been tendered for conversion or exchange into the security; (4) the person has an option to purchase the security and has exercised such option; or (5) the person has rights or warrants that have been exercised for the security. However, even if a seller “owns” the securities being sold, if the sale is consummated by the delivery of borrowed shares (e.g., the long position is “boxed”), the sale would be deemed to be a “short sale.”

Rule 200(c) further provides that a person (including both a natural or legal person) shall be deemed to own a security only to the extent that such person has a net long position in such security. Consistent therewith, 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 short position in a security, then a sale of the security by that person will be 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 Reg SHO, and the “uptick rule” of Rule 201 of Reg SHO, and the “close-out” requirement of Rule 204.

Rule 200(g) of Reg SHO requires executing brokers to mark all sell orders of any equity security as “long,” “short,” or “short exempt.” An order to sell can only be marked “long” if two conditions are met: (i) the seller must be “deemed to own” the security pursuant to Rule 200(a) through (f) of Reg SHO and must have a “net long position” in the security (i.e., any short positions must be subtracted from long positions to determine the seller’s net position); and (ii) the broker-dealer must either have possession or control of the security to be delivered on the sale, or reasonably expect that the security will be in the broker-dealer’s physical possession or control no later than the settlement of the transaction.

This being the case, Reg SHO provides exceptions from the “uptick,” “locate,” and “close-out” requirements of Rules 201, 203(b)(1), and 204 of Reg SHO for situations where a seller is “deemed to own” a security but delivery cannot be made on settlement date for reasons outside the seller's control, provided delivery will be made as soon as all restrictions on delivery have been removed and within at least 35 calendar days after trade date. Assuming that the stock in question is an exchange-listed stock (i.e., not solely traded OTC), then such sales shall be marked “short exempt.” This can be a highly fact-intensive analysis, however.

Federal Dealer Registration

Section 3(a)(5)(A) of the Exchange Act generally defines a “dealer” as any person “engaged in the business” of buying and selling securities for such person’s own account, whether through a broker or otherwise. Importantly, however, Section 3(a)(5)(B) of the Exchange Act excepts from this broad “dealer” definition any person who buys or sells securities for their own account, “but not as part of a regular business” (often referred to as the “trader exception” to the dealer definition).

Pursuant to Section 15(a)(1) of the Exchange Act, a person who uses U.S. interstate commerce to engage in “dealer” activities is generally required to be registered as such with the SEC, unless they are eligible to rely upon certain limited exceptions or exemptions that would not appear to be available in connection with the trading activities of the hedge fund.³

The SEC has issued various guidance over the years that is intended to distinguish between “dealer” activity and “trader” activity. Examples of activities that the SEC has identified as indicative of “dealer” (rather than “trader”) activity include, among others: (i) advertising or otherwise holding oneself out as willing to buy and sell securities on a continuous basis; (ii) purchasing and selling securities from or to customers; (iii) participating in a selling group or acting as an underwriter; (iv) carrying a dealer inventory of securities; (v) quoting a market in securities; (vi) using an interdealer broker for securities transactions; and (vi) providing certain related services — e.g., providing investment advice or extending or arranging for the extension of credit to others in connection with securities transactions. Hedge funds and mutual funds, in general, trade through brokerage accounts under the “trader” exception.

A key takeaway of this recent enforcement action is that the SEC is likely to identify an unregistered person to be acting as a “dealer” subject to the Exchange Act’s dealer registration provisions, and thus not as a trader, if such person “holds itself out” to the marketplace as being willing to purchase securities from an issuer (or other seller), assists the issuer (or other seller) in structuring an offering, and then lines up purchasers to immediately purchase the securities from such person so that the unregistered person is effectively capturing an underwriting “spread” or discount on the securities purchased and sold, even if the unregistered person subsequently effects all sales of the purchased securities through registered broker-dealers. In fact, an unregistered entity’s regularity of participation as an “underwriter” by seeking out, or soliciting, multiple issuers to engage in securities transactions, including through the sale of convertible debt securities that permit the purchaser to convert in the issuer’s underlying, and publicly traded common stock, interposing itself between an issuer and investors, even though the unregistered person sells through registered broker-dealers (particularly where the unregistered entity owns the securities for only a brief period of time, solicits the issuer and/or investors, as noted above, and resells the securities at a considerable premium over its own purchase price), appears to be one of the SEC’s more common bases for finding dealer activity.⁴ In several prior enforcement actions, the SEC seem particularly concerned about unregistered persons, in effect, “assisting” in the distribution of unregistered “microcap” securities that are securities (generally, common stock) of issuers with relatively small market capitalizations and that tend to be characterized by greater volatility.

Facts

According to the SEC, the Hedge Fund Adviser caused the hedge fund to enter into securities purchase agreements and convertible or exchange agreements with multiple issuers. Pursuant to these agreements, the hedge fund purchased hundreds of millions of dollars of the issuers’ securities that were convertible or exchangeable into common stock. From January 2016 through October 2017, on behalf of the hedge fund, the Hedge Fund Adviser placed multiple “long” sale orders of the issuers’ common stock before the hedge fund tendered the issuers’ convertible or exchangeable securities for common stock, and thus did not have a net long position in the stock or was not “deemed to own” the securities at the time of the sale.⁵ As a result, the Hedge Fund Adviser, and its principal and trader, provided erroneous order-marking information on hundreds of such sale orders to the hedge fund’s brokers, leading those brokers to mismark the hedge funds’ sales as “long” in violation of Rule 200(g) of Reg SHO. In addition, the SEC found that in providing the inaccurate order-marking information, the Hedge Fund Adviser caused the hedge fund’s brokers to fail to borrow or locate shares prior to executing the sales in violation of Rule 203(b)(1) of Reg SHO.

The Hedge Fund Adviser and its principal also settled charges for causing the hedge fund to engage in dealer activity without the hedge fund being registered as a dealer under the Exchange Act or exempt from registration. The Hedge Fund Adviser caused the hedge fund to enter into equity line agreements with multiple issuers, pursuant to which the issuer could sell a specified drawdown amount to be purchased by the hedge fund in a specified period. The Hedge Fund Adviser and the issuer ultimately agreed that after the hedge fund sold the issuer’s stock, the hedge fund could purchase an equivalent amount of stock from the issuer, rather than the initial drawdown amount, at a specified percentage of the hedge fund’s sales proceeds. In doing so, the Hedge Fund Adviser caused the hedge fund to sell the issuers’ common stock before purchasing, or entering into unconditional contracts to purchase, the stock being sold. In doing so, the hedge fund engaged in the regular business of buying and selling securities for its own account without registering with the SEC as a dealer, or being exempt from registration.⁶

The Hedge Fund Adviser and its principal agreed to pay, jointly and severally, disgorgement of $7 million, with prejudgment interest of $1,078,183. The Hedge Fund Adviser, its principal, and its trader also agreed to pay penalties of $800,000, $75,000, and $25,000, respectively.

Conclusion

This SEC settlement is a stark reminder of the need for market participants, even those who are not registered in any capacity with the SEC, to ensure compliance with SEC rules and regulations. In particular, this latest settlement emphasizes the need to comply with Reg SHO and broker-dealer registration requirements in connection with market participants, including advisers to private funds, providing financing to issuers in return for receiving stock that the adviser then sells. In this regard, even though the obligations of Reg SHO primarily are the responsibility of broker-dealers, market participants also need to be mindful of Reg SHO compliance, or risk being accused of “causing” broker-dealers to violate the regulation.

¹ See Litigation Release No. 92684 (August 17, 2021).

² The SEC has always had a high degree of interest in the potential abuses related to such financing arrangements that hedge funds enter into with issuers and has recently brought actions against broker-dealers in addition to this action against a hedge fund.  

³ Section 15(a)(1) also generally requires persons that use U.S. interstate commerce to engage in securities “broker” activities to register as such with the SEC. Section 15(a)(1) includes an exception from the registration requirements for transactions in certain limited types of securities, including exempted securities. Sections 15B and 15C of the Exchange Act contain additional registration provisions specific to municipal securities dealers and government securities brokers and government securities dealers, respectively. Separate from the federal registration provisions, “broker-dealer” registration requirements may also arise under applicable states’ so-called “Blue Sky” or securities laws.

⁴ See, e.g., SEC v. John M. Fife, et al., Litigation Release No. 24886 (September 30, 2020), SEC v. Ibrahim, Almagarby, et al., Litigation Release No. 24871 (August 20, 2020), SEC v. Justin W. Keener d/b/a JMJ Financial, Litigation Release No. 24779 (March 24, 2020), In the Matter of Ironridge Global Partners, LLC, Exchange Act Release 81443 (August 21, 2017), In the Matter of Timothy T. Page, Exchange Act Release No. 67611 (August 7, 2012), and In the Matter of Regency Group, LLC, Exchange Act Release No. 65757 (November 16, 2011).

⁵ As previously noted, SEC Rule 200(b)(3) of Reg SHO provides that a person is deemed to own a security if a person owns a security convertible into or exchangeable for it and has tendered such security for conversion or exchange (italics added).

⁶ As previously noted, this is not the first time the SEC has sued a hedge fund for activities it viewed as those of a “dealer.” In 2015, the Commission brought an action against Ironridge Global Partners based on its activities in selling a significant amount of stock it had obtained in the context of bankruptcy proceedings. Even though the fund sold the stock though registered broker-dealers, the SEC viewed it as acting in the capacity of a statutory underwriter. In re Ironridge Global Partners, LLC, Admin Proceeding 3- 16649, June 23, 2015.