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Hedge Funds Should Beware of Rule 105

Hedge fund firm Carlson Capital found itself the target of the Securities and Exchange Commission’s crackdown on short-selling.

Another hedge fund firm found itself the target of the Securities and Exchange Commission’s crackdown on short-selling.

The SEC said Thursday that Carlson Capital agreed to pay more than $2.6 million to settle SEC charges of improperly participating in four public stock offerings after selling short those same stocks. The Dallas-based firm agreed to the settlement without admitting to or denying the findings.

Carlson was founded in 1993 by Clint Carlson and is investment adviser to the Black Diamond group of multistrategy hedge funds. It manages $5.1 billion.

The firm was accused of violating the SEC’s Rule 105 of Regulation M, which prohibits selling short stocks during a restricted period — generally five business days before a public offering — and the purchase of that same security through the offering. The rule exists to ensure that “offering prices are set by natural forces of supply and demand rather than manipulative activity,” the SEC says.

The SEC believes that the rule prevents short-selling that could reduce proceeds received by companies and shareholders by artificially depressing the market price just before the company prices its public offering.

However, the rule can be confusing. For example, the SEC alleges that in one case, Carlson violated Rule 105 even though the portfolio manager who sold short the stock and the portfolio manager who bought the offering shares were different. “Investment advisers must recognize that combined trading by different portfolio managers can still constitute a clear violation of Rule 105 when short-selling takes place during a restricted period,” noted Antonia Chion, associate director of the SEC’s Division of Enforcement, in a press release. “This is true even when the portfolio managers have different investment approaches and generally make their own trading decisions.”.

Carlson is the third major hedge fund and fourth investment firm to settle charges of violating Rule 105. In July, David Tepper’s Appaloosa Management agreed to pay $1.3 billion, including disgorging $842,500 in profits, after being accused of violating the short-selling rule while trading Wells Fargo’s stock. Appaloosa also agreed to the settlement without admitting to or denying the findings.

Back in January the SEC settled two separate Rule 105 cases in one day — the first cases since the rule was amended in 2007. In one instance, the SEC accused Los Angeles–based Palmyra Capital Advisors of violating Rule 105 in connection with short sales made in advance of a public offering by Capital One Financial, resulting in profits of $225,500. The firm paid $341,000 in disgorgement, prejudgment interest and civil penalties.

On the same day, the SEC settled charges against AGB Partners, a California limited liability corporation whose primary place of business is Boise, Idaho, but which also has an office in Santa Monica, California. The firm is an investment adviser that advises two private investment funds. It also settled charges with owners Gregory Bied and Andrew Goldberger.

AGB Partners managed two investment funds. One fund was AGB’s own account, which consisted solely of funds from its two principals. The other was Del Rey Management, which raised and invested funds primarily from outside investors.

The SEC alleges that in April 2007, AGB and the two individuals violated Rule 105 by covering short sales of the stock of Boots and Coots International Well Control in the AGB Partners account, with shares of Boots and Coots obtained in a follow-on offering in the Del Rey Account.

In June 2008 they allegedly violated Rule 105 related to a follow-on offering by BGC Partners. AGB Partners shorted shares in the AGB Partners account during the restricted period while its other client, Del Rey, purchased follow-on offering shares of the same company in the Del Rey account. Total profits: $23,740.

Bied and Goldberger jointly disgorged $38,444 in profits and paid prejudgment interest of $2,921, together with a civil penalty of $20,000.

“We expect the SEC to continue its enforcement efforts with respect to violations of Rule 105,” law firm Willkie Farr & Gallagher warned clients after the two January cases were settled. “Penalties imposed on market participants who commit such violations are likely to be significant.”.

No doubt its clients now realize the law firm was not exaggerating.

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