Study guide
This chapter continues Function 1 with the product-specific rules a trader must apply in the moment: what you may and may not do while a distribution is under way, how quoting works in the OTC market, the mechanics of options positions, and the full architecture of Regulation SHO. These areas generate some of the most fact-specific questions on the exam, so learn the exact triggers and time frames.
Regulation M: Protecting the Offering Price
Regulation M exists because everyone involved in a securities offering has an incentive to prop up the price while shares are being sold. Rule 101 restricts distribution participants, meaning underwriters and broker-dealers in the syndicate, from bidding for or purchasing the offered security during a restricted period, and Rule 102 imposes similar restrictions on the issuer and selling security holders. The restricted period is generally one business day before pricing for securities with average daily trading volume of at least 100,000 dollars and a public float of at least 25 million dollars, and five business days for everything else; actively traded securities, those with ADTV of at least 1 million dollars and public float of at least 150 million dollars, are excepted from Rule 101 entirely, though the issuer itself remains restricted. Rule 104 permits one narrow form of price support: a single stabilizing bid, entered by the syndicate manager to prevent or retard a decline, never higher than the offering price and capped by independent market prices, and disclosed to the market where it is entered. A penalty bid, which lets the manager reclaim the selling concession from syndicate members whose customers immediately flip their shares, is also permitted with disclosure. Rule 103 offers Nasdaq market makers in the syndicate a middle path called passive market making: instead of withdrawing quotes entirely during the restricted period, the firm may keep quoting so long as its bid never exceeds the highest independent bid, its quotes are identified as passive, and its daily net purchases stay within prescribed limits tied to its own recent trading volume.
Rule 105 Short Sales and Issuer Buybacks Under 10b-18
Rule 105 of Regulation M attacks a specific arbitrage: shorting a stock to push it down just before a follow-on offering prices, then covering with cheap offering shares. The rule prohibits purchasing securities in a firm commitment offering if you sold the security short during the Rule 105 restricted period, which is the shorter of the five business days before pricing or the period between the initial filing of the registration statement and pricing. A bona fide purchase exception lets a trader cure the violation by buying back at least the shorted quantity in the open market, during regular hours and reported, before the pricing day, and separate account and registered investment company exceptions exist. For example, if Priya at Brightline shorts Corvid Industries three days before its secondary prices, Brightline cannot buy in that offering unless she has made a qualifying bona fide purchase first. Issuer repurchases raise the mirror-image concern, an issuer supporting its own price, and Rule 10b-18 answers with a voluntary safe harbor rather than a prohibition. An issuer buying back common stock avoids a manipulation presumption if, on any given day, it satisfies four conditions: manner, using a single broker or dealer per day; timing, never making the opening purchase and staying out of the final minutes of trading, generally the last 10 minutes for actively traded securities and the last 30 minutes for others; price, paying no more than the higher of the highest independent bid or the last independent transaction price; and volume, buying no more than 25 percent of average daily trading volume, with a once-weekly block purchase alternative. Missing a condition forfeits the safe harbor for all of that day's purchases but is not automatically manipulation.
Quoting OTC Equities: 15c2-11, Form 211, and Penny Stock Rules
Before a broker-dealer may publish a quotation for an OTC equity in a quotation medium, Exchange Act Rule 15c2-11 requires it to review current information about the issuer, such as recent financial statements, and have a reasonable basis for believing the information is accurate and from a reliable source. Under FINRA Rule 6432, the firm demonstrates compliance by filing Form 211 with FINRA at least three business days before publishing the quote. Once a security has been quoted regularly, other firms can rely on the piggyback exception and quote without their own review; regular quoting generally means the security appeared in the quotation system on at least 12 of the previous 30 calendar days with no gap of more than four consecutive business days. Amendments effective in 2021 tightened the regime substantially: issuer information generally must be current and publicly available for piggybacking to continue, shell companies have limited piggyback windows, and securities that fall out of compliance are relegated to unsolicited quotes in the expert market. FINRA Rule 6433 sets minimum quotation sizes for OTC equities in tiers based on price, ranging from as little as one share for very high-priced securities to 10,000 shares for the lowest-priced tier. Penny stocks, generally non-exchange-listed equities priced under 5 dollars, carry their own retail protections under the 15g rules: a standardized risk disclosure document the customer must receive and acknowledge before the first trade, a signed suitability determination for customers who are not established, disclosure of current quotes and of the compensation earned by the firm and its representative, and monthly account statements showing the market value of penny stock positions.
Options: Order Types, Exercise, Assignment, and Position Limits
Options orders travel with an extra dimension: every order is marked opening or closing, because building a position and unwinding one have different regulatory and margin consequences. The order type toolbox largely mirrors equities, with market, limit, and stop instructions, plus spread and combination orders that must execute as a package. American-style equity options can be exercised any business day; European-style options, common for some index products, only at expiration. When a holder exercises, the clearing member submits an exercise notice to the Options Clearing Corporation, which assigns the obligation randomly among clearing members carrying short positions in that series; the assigned firm then allocates to its short customers by a fair method it has disclosed, typically random selection or first-in-first-out. At expiration, the OCC's exercise-by-exception procedure automatically exercises any equity option that is in the money by at least one cent, unless the holder delivers contrary instructions by the firm's cutoff time on expiration day. So if Marcus holds calls on Corvid Industries that finish two cents in the money and does nothing, he will own the stock Monday morning whether he wanted it or not. Position limits cap the number of contracts a person, acting alone or in concert, may hold on the same side of the market in one underlying security: long calls aggregate with short puts as the bullish side, and short calls with long puts as the bearish side. The limits are tiered by the underlying security's trading volume and shares outstanding, running from 25,000 contracts up to 250,000 or more for the most active names, and parallel exercise limits cap contracts exercised within five consecutive business days.
Regulation SHO: Marking, Locates, the Circuit Breaker, and Close-Outs
Regulation SHO governs short selling end to end. Rule 200 requires every sell order to be marked long, short, or short exempt, and an order may be marked long only if the seller is net long the security and it can be delivered by settlement. Rule 203(b)(1), the locate requirement, forbids a broker-dealer from accepting or effecting a short sale unless it has borrowed the security, arranged to borrow it, or has reasonable grounds to believe it can be borrowed in time for delivery, with the locate documented before the trade; bona fide market making activity is excepted. Rule 201 is the short sale circuit breaker: once a covered security falls 10 percent or more intraday from its prior day's closing price, short sales may execute or display only at a price above the current national best bid, for the remainder of that day and the entire next trading day. Certain orders, such as those a broker-dealer has confirmed qualify, may be marked short exempt and trade through the restriction. Rule 204 disciplines settlement failures. A clearing agency participant that fails to deliver on a short sale must close out the fail by purchasing or borrowing shares no later than the beginning of regular trading hours on the settlement day after the settlement date; fails from long sales or bona fide market making get until the third settlement day after the settlement date. A firm that misses a close-out lands in the penalty box: it may not accept further short sales in that security from anyone without a pre-borrow until the fail is cured. Securities with large persistent fails, at least 10,000 shares and half a percent of shares outstanding for five consecutive settlement days, appear on the threshold list and face additional mandatory close-out provisions.
Key terms
- Restricted period
- — The window before pricing during which Regulation M limits bids and purchases by distribution participants: generally one business day for securities with ADTV of 100,000 dollars and float of 25 million dollars, five business days otherwise.
- Actively traded security
- — A security with ADTV of at least 1 million dollars and public float of at least 150 million dollars, excepted from Rule 101 restrictions, though the issuer itself remains restricted under Rule 102.
- Stabilizing bid
- — The single syndicate bid permitted by Reg M Rule 104 to prevent or slow a decline in a new issue, never above the offering price, capped by independent market prices, and disclosed.
- Penalty bid
- — A disclosed arrangement letting the syndicate manager reclaim selling concessions from members whose customers quickly flip offering shares.
- Passive market making
- — Reg M Rule 103 relief letting a Nasdaq market maker in the syndicate keep quoting during the restricted period, with bids no higher than the highest independent bid, identified quotes, and daily net purchase limits.
- Rule 105
- — The Reg M rule barring purchases in a firm commitment offering by anyone who sold the security short during the restricted period, the shorter of five business days before pricing or the filing-to-pricing window, subject to a bona fide purchase cure.
- Rule 10b-18 safe harbor
- — The voluntary issuer buyback safe harbor with four daily conditions: one broker per day, timing limits at the open and close, a price cap at the higher of the highest independent bid or last independent sale, and volume of at most 25 percent of ADTV.
- Form 211
- — The form a broker-dealer files with FINRA, at least three business days before quoting, to demonstrate its Rule 15c2-11 review of current issuer information for an OTC equity.
- Piggyback exception
- — The 15c2-11 exception letting firms quote an OTC security already quoted regularly, generally 12 of the previous 30 calendar days without a gap over four consecutive business days, provided issuer information remains current and publicly available.
- Position limit
- — The cap on same-side-of-the-market options contracts in one underlying, aggregating long calls with short puts and short calls with long puts, tiered by the underlying security's volume and float.
- Locate requirement
- — Reg SHO Rule 203(b)(1)'s demand that, before a short sale, the firm has borrowed, arranged to borrow, or has documented reasonable grounds to believe it can borrow the security for timely delivery; bona fide market makers are excepted.
- Rule 204 close-out
- — The requirement to purchase or borrow shares to cure a fail to deliver by the open of regular trading hours on the settlement day after settlement date for short sale fails, or the third settlement day for long sale and market-making fails, with a pre-borrow penalty box for firms that miss.
Exam tips
- Map each Reg M rule to its actor: 101 covers syndicate participants, 102 covers issuers and selling holders, 103 is passive market making, 104 is stabilization and penalty bids, and 105 is short selling before pricing.
- Rule 105's restricted period is the shorter of five business days before pricing or filing-to-pricing, and the remedy for a violation already in motion is the bona fide open-market purchase before pricing day.
- For 10b-18, recite the four conditions in order: manner (one broker per day), timing (not the open, not the last 10 or 30 minutes), price (no higher than the greater of highest independent bid or last independent sale), and volume (25 percent of ADTV, or one block a week instead).
- On Reg SHO, connect each number to its trigger: 10 percent intraday decline activates Rule 201 for the rest of the day plus the next day, and the threshold list requires fails of 10,000 shares and 0.5 percent of shares outstanding for five straight settlement days.
- Remember that options position limits aggregate the same side of the market: long calls plus short puts on one side, short calls plus long puts on the other, and exercise limits mirror position limits over five business days.