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E-MailPatrick M. Corrigan is Associate Professor of Law at Notre Dame Law School. This post is a reply to a recent response to his earlier post.
I am very grateful to Mr. Evans for his thoughtful reply to my prior post on the Forum. His reply raises important interpretive issues that I hope that the SEC and FINRA will directly address.
In connection with U.S. initial public offerings (IPOs), underwriters usually trade in the issuer’s stock for their own principal accounts, including by short selling the issuer’s stock and by exercising a green shoe option. I have argued that applicable U.S. law permits underwriters, subject to certain compliance measures, to monetize the value of their principal trading positions.
Mr. Evans’s reply post makes the empirical claim that underwriters do not use the green shoe option to profit from IPO stock pops. Mr. Evans asserts this empirical claim on the basis of deductive logic. According to Mr. Evans, Regulation M permits underwriters to pick one and only one of the following two activities: (1) making a market in an issuer’s stock as soon as exchange trading begins, and (2) profiting from IPO stock pops. Since we observe underwriters making markets once exchange trading begins, Mr. Evans concludes, underwriters do not use green shoe options to profit from IPO stock pops.
The sole basis for the either/or premise in Mr. Evans’s deductive argument is not an authoritative interpretation of Regulation M, but rather his reading of one of its provisions: “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 such exercise” (emphasis added).
Based on this language, Mr. Evans concludes that “if [underwriters] did not overallot all of the shares but instead sold them during the 30-day green shoe window, they would not have concluded their participation in the distribution until after they had sold those shares.”
I disagree with this interpretation of Regulation M, which reads the words “at the time of such exercise” out of the text of Regulation M. As I trace more completely in my paper, the plain text of the proviso at issue generally provides no basis for the SEC to restrict underwriter market making activities, syndicate short covering activities, or syndicate short selling activities after a distribution has ended and before the green shoe option is exercised. The proviso cited above provides such a basis only if underwriters possess excess inventory of the issuer’s stock after applying option shares to the net syndicate short position at the time the option is exercised.
Thus, we have two very different interpretations of Regulation M. The SEC has effectively delegated the interpretation of this important provision to each individual market participant by failing to authoritatively address its ambiguities.
For the sake of argument, however, I will accept Mr. Evans’s narrow interpretation of this important proviso in Regulation M. The key premise in Mr. Evans’s deductive argument still does not hold. A single example should suffice to establish this point.
Due to the limited extraterritorial reach of Regulation M, underwriters may monetize the green shoe option after making markets in the U.S. through sales completely outside the United States. This conclusion is right in the fairway of no-action relief referenced in the preamble to the Final Rule establishing Regulation M (the successor rule to Rule 10b-6) in which the SEC staff took the view that: “Rule 10b-6 does not prohibit the underwriters’ exercise of an Overallotment Option in an amount that exceeds the remaining net syndicate short position, as long as further offers or sales on behalf of the syndicate account do not occur in the United States and do not result in a resumption of the offering in the United States” (1996 WL 683203).
Thus, with appropriate compliance measures, Regulation M should pose no barrier to underwriters making markets in the issuer’s stock as soon as trading begins and profiting from IPO stock pops.
In response to the troubling incentives that arise if underwriters can trade in and out of the issuer’s stock for their principal accounts in connection with a securities distribution, I proposed, among other reforms, that the SEC should require underwriters to disgorge any principal trading profits made in connection with short sales or green shoe options that exceed negotiated discounts and commissions. I also argued, as a descriptive matter, that such profits constitute “underwriting compensation” under FINRA’s corporate financing rule, and that FINRA should change its practice of not accounting for these profits in its pre-review of securities offerings.
Mr. Evans characterizes my proposals as designed to police underwriting arrangements and to protect “naïve” issuers. Mr. Evans labels my arguments for these proposals as “insidious,” and advocates for the importance of letting sophisticated parties adapt to new developments in the law and markets.
Mr. Evans employs the wrong normative and policy template.
Security price manipulation—which is the primary concern of the prophylactic provisions of Regulation M—is not left to the rough and tumble of sophisticated market actors; it is categorically prohibited under Section 9 of the Exchange Act as a matter of market integrity. The regulatory exception in Regulation M that permits underwriters to lawfully manipulate prices through stabilization is extraordinary. Given that the SEC has long recognized that certain underwriter trading activities during a securities distribution create risks of distorting capital formation and harming investors, the SEC ought to ensure that Regulation M is constructed and interpreted to ensure the public benefits which justify the exception.
In my view, the bottom line is that public primary markets are too important to the welfare of society to permit distortions in allocation efficiency due to underwriter principal trading activities.
