The Regulation M Restricted Period

Two rules carry the same prohibition against two different sets of people, and each has its own list of excepted activities and excepted securities. Reading the wrong list is the commonest way to get one of these questions wrong.

How Long Is the Restricted Period?

Regulation M's definitions state the restricted period in three branches. The first two begin on the later of two events and end on the same event; the third runs on a different clock entirely.

The split between the first two turns on average daily trading volume (ADTV) and public float value.

Both tests in the first branch must hold. A security with the volume but not the float falls into the five-business-day branch.

Exam Tip: Gotchas

• The first two branches end on a personal event and the third ends on a deal event. A participant in an ordinary distribution is released at its own completion of participation, while the merger branch runs to completion of the distribution itself.
• "The later of" can start a late joiner's period after the pricing-based date. A firm that becomes a distribution participant three days before pricing in a five-day security starts its own period on that later date, not five days back.

When Has a Person Completed Its Participation?

Securities acquired in the distribution for investment by any person participating in a distribution, or any affiliated purchaser of that person, shall be deemed to be distributed. From there, completion depends on who the person is.

• An issuer or selling security holder completes participation when the distribution is completed.
• An underwriter completes participation when its participation has been distributed, including all other securities of the same class that are acquired in connection with the distribution, and any stabilization arrangements and trading restrictions in connection with the distribution have been terminated.
• Any other person participating in the distribution completes participation when that person's participation has been distributed.

The underwriter branch carries a proviso: an underwriter's participation will not be deemed to have been completed if a syndicate overallotment option is exercised in an amount that exceeds the net syndicate short position at the time of that exercise.

Exam Tip: Gotchas

• Holding distribution shares for investment does not extend the restricted period. Those securities are deemed distributed, so a participant cannot keep its own period alive by parking stock.
• An overallotment exercise can keep an underwriter's participation from being treated as completed. The proviso bites only where the exercise exceeds the net syndicate short position at the time of exercise, not on every exercise.

What Does the Prohibition Actually Ban?

Regulation M's distribution participant rule makes it unlawful, in connection with a distribution of securities, for a distribution participant or an affiliated purchaser of such person, directly or indirectly, to bid for, purchase, or attempt to induce any person to bid for or purchase, a covered security during the applicable restricted period.

Its proviso routes overlapping actors: if a distribution participant or affiliated purchaser is the issuer or selling security holder of the securities subject to the distribution, that person is subject to Regulation M's issuer and selling security holder rule instead.

That second rule applies the same three-verb prohibition to the issuer or selling security holder, and to any affiliated purchaser of that person, in connection with a distribution effected by or on behalf of that person. Its exception runs the other way: if an affiliated purchaser is a distribution participant, that affiliated purchaser may comply with the distribution participant rule rather than the issuer rule.

Exam Tip: Gotchas

• Attempting to induce is the third prohibited verb. A firm that neither bids nor buys, but calls accounts to get them to bid, is inside the prohibition.
• The two rules route overlapping actors in opposite directions. An issuer that is also a distribution participant goes to the issuer rule; an affiliated purchaser that is a distribution participant may elect the distribution participant rule.

Which Activities Are Excepted for a Distribution Participant?

Ten activities are excepted from the distribution participant prohibition.

Exam Tip: Gotchas

• The de minimis purchase limb is not available to a passive market maker. That limb is written "other than by a passive market maker", and it also carries its own written policies and procedures condition.
• The reasonable-belief branch of the resale exception covers two people. It reaches what the seller and any person acting on behalf of the seller reasonably believes, not the seller alone.

Which Securities Are Excepted for a Distribution Participant?

Four classes are outside the distribution participant rule entirely:

• Actively-traded securities: securities that have an ADTV value of at least $1 million and are issued by an issuer whose common equity securities have a public float value of at least $150 million, provided that those securities are not issued by the distribution participant or an affiliate of the distribution participant.
• Certain nonconvertible and asset-backed securities: nonconvertible debt securities and nonconvertible preferred securities meeting the rule's default-probability test, and asset-backed securities offered under an effective shelf registration statement on the Commission's asset-backed form.
  • The default-probability test requires an issuer probability of default of 0.055% or less, estimated as of the sixth business day immediately before the offering price is determined, over a horizon of 12 full calendar months from that day.
  • The distribution participant acting as lead manager (or in a similar capacity) must determine and document that estimate in writing, deriving it from a structural credit risk model.
• Exempted securities: exempted securities as the Exchange Act defines them.
• Face-amount certificates and certain fund securities: face-amount certificates issued by a face-amount certificate company, or redeemable securities issued by an open-end management investment company or a unit investment trust.

Exam Tip: Gotchas

• The actively-traded test is conjunctive and carries a proviso. Volume of at least $1 million and float of at least $150 million must both hold, and the securities must not be issued by the distribution participant or its affiliate.
• An excepted security removes the whole rule, not one trade. These four classes are outside the section entirely, which is a different thing from an excepted activity inside it.

Which Activities and Securities Are Excepted for an Issuer or Selling Security Holder?

The issuer rule's own list is seven activities, not ten, and it is not a copy of the other list.

The excepted securities list also has four classes, and its first is narrower than its counterpart. It excepts actively-traded reference securities on the same $1 million volume and $150 million float test, provided that those securities are not issued by the issuer, or any affiliate of the issuer, of the security in distribution.

The other three classes match: the nonconvertible and asset-backed class, exempted securities, and face-amount certificates or open-end fund and unit investment trust securities.

Exam Tip: Gotchas

• The actively-traded exception is not symmetric. The distribution participant rule excepts actively-traded securities; the issuer rule excepts only actively-traded reference securities.
• The two provisos name different people. One excludes securities issued by the distribution participant or its affiliate; the other excludes securities issued by the issuer of the security in distribution, or that issuer's affiliate.
• The issuer's excepted-activity list has no research entry, no entry for transactions complying with Regulation M's passive market making rule or its stabilization rule, and no basket, de minimis or among-participants entry. Those five exist only on the distribution participant side.

How Are Plan Purchases Treated?

The issuer rule does not apply to distributions of securities pursuant to a plan made in either of two ways:

• Solely to employees or security holders of an issuer or its subsidiaries, or to a trustee or other person acquiring those securities for the accounts of such persons.
• To persons other than employees or security holders, if bids for or purchases of securities pursuant to the plan are effected solely by an agent independent of the issuer and the securities are from a source other than the issuer or an affiliated purchaser of the issuer.

A bid for or purchase of any security made or effected by or for a plan is deemed to be a purchase by the issuer, unless the bid is made, or the purchase is effected, by an agent independent of the issuer.

A plan means any bonus, profit-sharing, pension, retirement, thrift, savings, incentive, stock purchase, stock option, stock ownership, stock appreciation, dividend reinvestment, or similar plan; or any dividend or interest reinvestment plan or employee benefit plan as the Securities Act rules define that term.

An agent independent of the issuer is a trustee or other person who is independent of the issuer, and the agent is deemed independent only if both of the following hold:

• The agent is not an affiliate of the issuer.
• Neither the issuer nor any affiliate of the issuer exercises any direct or indirect control or influence over the prices or amounts of the securities to be purchased, the timing of or the manner in which they are to be purchased, or the selection of a broker or dealer (other than the independent agent itself) through which purchases may be executed.

The second condition carries a proviso. The issuer or its affiliate is not deemed to have that control or influence solely because it revises not more than once in any three-month period any of four things:

• The source of the shares to fund the plan.
• The basis for determining the amount of its contributions to a plan.
• The basis for determining the frequency of its allocations to a plan.
• Any formula specified in a plan that determines the amount or timing of securities to be purchased by the agent.

Exam Tip: Gotchas

• A plan purchase is the issuer's purchase by default. The deeming rule reverses only where an agent independent of the issuer makes the bid or effects the purchase.
• A second revision does not by itself end the agent's independence. It only takes the issuer outside the proviso; independence then turns on whether the issuer or an affiliate exercises any direct or indirect control or influence over the prices or amounts, the timing or manner of purchase, or the selection of a broker or dealer.

What Should You Check on Exam Day?

• Check volume and float together before choosing one business day; failing either test moves the security to the five-business-day branch.
• Identify the actor first. A distribution participant reads one rule, an issuer or selling security holder reads the other, and the two exception lists differ.
• On an actively-traded question, check whether the security in the stem is the subject security or a reference security, and read the matching proviso.
• Where an overallotment option is exercised, compare the amount exercised with the net syndicate short position at that moment.
• For a plan purchase, confirm the agent is not an affiliate of the issuer and that neither the issuer nor any affiliate of the issuer exercises direct or indirect control or influence over price, amount, timing, manner or broker selection.