What Is Regulation M? Its Rules and Prohibitions Explained

Regulation M, established by the Securities and Exchange Commission (SEC) in 1996, prevents manipulative practices during securities offerings. It replaced older rules to create a cohesive framework, aiming to maintain market integrity and ensure fair pricing. The regulation addresses concerns about artificial influence on security prices, which could mislead investors and distort market dynamics.

Purpose and Applicability of Regulation M

Regulation M’s purpose is to prevent activities that could artificially influence a security’s price during its distribution, ensuring offering prices result from natural supply and demand. It applies to various market participants involved in a securities distribution, particularly during initial public offerings (IPOs) and secondary offerings. These include issuers (companies offering securities), underwriters (financial institutions managing the offering), prospective underwriters, broker-dealers, and selling security holders (major shareholders selling shares). Affiliated purchasers, defined as any person acting in concert with these primary participants, must also comply. A “distribution” refers to an offering of securities distinguished from ordinary trading by its magnitude and special selling efforts.

Activities Prohibited During Distributions

Regulation M broadly prohibits activities that could manipulate the market during a securities distribution. These restrictions prevent actions that might create an artificial appearance of active trading or improperly influence a security’s price. Participants are generally restricted from bidding for, purchasing, or inducing others to bid for or purchase, the security being offered. This includes any “covered security” (the subject of the distribution) or any “reference security” convertible into the distributed security.

These prohibitions counteract efforts that could artificially inflate or depress a security’s price. They ensure the offering price is determined by genuine market forces, not pre-arranged or manipulative trading.

Specific Rules of Regulation M

Regulation M consists of several specific rules designed to address various aspects of market manipulation during securities offerings. Rule 100 provides definitions for terms used throughout the regulation, establishing a common understanding. The subsequent rules detail the prohibitions and permitted activities for different market participants.

Rule 101 (Activities of Distribution Participants)

Rule 101 generally prohibits distribution participants, such as underwriters and broker-dealers, from bidding for, purchasing, or attempting to induce others to purchase, a covered security or any reference security during a restricted period. The “restricted period” is a crucial element, varying based on the security’s liquidity. For securities with an average daily trading volume (ADTV) of at least $1 million and a public float of at least $150 million, there is generally no restricted period, as their markets are considered too deep to be easily manipulated. For other securities, the restricted period can be either one business day or five business days before the pricing of the offering, ending upon the participant’s completion of the distribution. Exceptions exist for activities such as publishing research reports, engaging in passive market making, or bona fide unsolicited purchases.

Rule 102 (Activities of Issuers and Selling Security Holders)

Rule 102 extends prohibitions to issuers and selling security holders, along with their affiliated purchasers. These parties are restricted due to their direct interest in the offering’s success, which could incentivize manipulative behavior. This rule prohibits bidding for, purchasing, or inducing others to purchase the covered security during the applicable restricted period. Common exceptions include transactions involving odd-lots, exercises of options, warrants, or rights, and certain unsolicited transactions.

Rule 103 (Passive Market Making)

Rule 103 provides a limited exception allowing a market maker to continue providing liquidity in a Nasdaq-listed security that is subject to a distribution. This “passive market making” is permitted without violating Regulation M, provided strict conditions are met. A passive market maker’s bids and purchases cannot exceed the highest independent bid for the security at the time of the transaction. There are also volume limitations, generally restricting daily purchases to a certain percentage of the market maker’s average daily trading volume, or 30% of its ADTV. This rule helps maintain market liquidity during offerings while ensuring the activity remains non-manipulative.

Rule 104 (Stabilization and Syndicate Covering Transactions)

Rule 104 addresses stabilization activities, which are bids or purchases intended to prevent a disorderly decline in the offering price. While generally prohibited, stabilization is permitted under specific conditions to facilitate an orderly distribution of securities. Only one stabilizing bid is allowed at a time, and it cannot exceed the public offering price or the highest independent bid. Extensive disclosure requirements apply to any stabilization efforts. The rule also covers syndicate covering transactions, which are purchases made by an underwriting syndicate to cover short positions created through overallotments in an offering.

Rule 105 (Short Selling in Connection with a Public Offering)

Rule 105 prohibits certain short sales made within a specific period before the pricing of a new offering, if the short seller then purchases the offered security from an underwriter or broker-dealer in the offering. This rule is designed to prevent manipulative short selling that could artificially depress the offering price. The restricted period typically begins five business days before the pricing of the offered securities and ends at the pricing. Exceptions include bona fide purchases that close out the short position before pricing, or purchases by separate, independently managed accounts. The SEC has actively enforced Rule 105, collecting substantial penalties for violations.

Exemptions from Regulation M

Regulation M includes exemptions for certain transactions and securities where the risk of manipulation is low. These exemptions help streamline the offering process.

One common exemption applies to actively traded securities, characterized by a high average daily trading volume (ADTV) and a large public float. For equity securities, this means an ADTV of at least $1 million and a public float of at least $150 million. Such deep and liquid markets are less susceptible to manipulation.

Certain types of debt and preferred securities also have exemptions. Historically, nonconvertible debt securities and preferred stock were exempt due to their yield and creditworthiness-based trading. Recent 2023 amendments replaced the “investment grade” standard with a credit risk-based exception, requiring lead managers to determine and document a low probability of default for nonconvertible securities. Asset-backed securities offered under an effective shelf registration statement on Form SF-3 are generally exempt.

Specific transaction types are also excepted from Regulation M’s restrictions. These include unsolicited brokerage transactions and exercises of options, warrants, or rights. The SEC retains the authority to grant specific exemptions on a case-by-case basis. Even when an exemption applies, general anti-fraud and anti-manipulation provisions of federal securities laws remain in full effect.