Series 79: 9.3.5. Restrictions On Short Selling Prior To Pricing

9.3.5. Restrictions on Short Selling Prior to Pricing

Recall from Chapter 2’s discussion of short selling that in a typical short sale, the short-seller borrows shares and then sells them, hoping that the price drops before he must buy shares on the secondary market to return to the lender. In the case of a follow-on offering for a class of securities already in circulation, it is possible for a short-seller to borrow and sell existing shares, but then purchase and return the newly offered shares.

The SEC became concerned that short selling shortly before a follow-on offering could depress the market for the offered securities. The share prices of follow-on offerings are typically set at a discount to the market price. If a short-seller aggressively shorts the security right before the offering, it can depress the market price, causing the offering price to be even lower. A short-seller who covers her short position with securities bought in the follow-on offering could then benefit from this artificial price depression. Regulation M, Rule 105, was put into place to restrict this strategy of manipulating the market.