The measure runs from the short sale prices, not from the allocation discount, so it is usually far larger than the trade looked on the desk.
The profit figure the SEC typically uses for a Rule 105 violation is the difference between the price of each share sold short in the restricted period and the offering price, summed over those shares. An illustrative fund that sold 60,000 shares short at an average of $30.85 in the five business days before pricing, then bought in a $28.75 offering, has a profit measure of $125,750. That is 2.47 times the $51,000 the allocation discount itself was worth on the same shares, because it captures the whole fall in the share price, not just the discount.
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Rule 105 of Regulation M stops a person who sold a security short during the restricted period from buying the same security in a firm commitment offering. The restricted period is generally the five business days before pricing, or the time from filing to pricing if that is shorter. The rule has no intent requirement, and since the 2007 amendments it does not matter whether the offering shares are used to cover the short. The purchase is the violation. Exceptions exist, notably a bona fide purchase of the same quantity after the last restricted short and separate accounts with independent decision-making, but each has strict conditions and none is a defence that can be assembled after the fact.
| Trade | Shares | Price | Proceeds |
|---|---|---|---|
| Short sale two weeks before pricing | 30,000 | $32.00 | 960,000 |
| Restricted period, sale 1 | 20,000 | $31.40 | 628,000 |
| Restricted period, sale 2 | 25,000 | $30.85 | 771,250 |
| Restricted period, sale 3 | 15,000 | $30.10 | 451,500 |
| Offering allocation bought | 100,000 | $28.75 | |
| Closing price the day after pricing | $29.60 |
1. Keep only the restricted-period shorts. The 30,000 shares sold two weeks before pricing are outside the window and drop out. That leaves 60,000 shares with proceeds of $1,850,750, an average of $30.85.
2. Price them at the offering price. 60,000 × $28.75 = $1,725,000.
3. Take the difference. $1,850,750 − $1,725,000 = $125,750, or $2.10 a share.
Trade by trade: 20,000 × ($31.40 − $28.75) = 53,000; 25,000 × ($30.85 − $28.75) = 52,500; 15,000 × ($30.10 − $28.75) = 20,250.
In Excel, with restricted shares in B2:B4, prices in C2:C4 and the offering price in F1: =SUMPRODUCT(B2:B4,C2:C4-F1).
The fund here bought more offering shares than it sold short in the window, so every restricted short is in the calculation. Settled SEC orders under Rule 105 have typically required this amount to be disgorged, with prejudgment interest and a civil penalty on top.
The portfolio manager's view of the trade is usually narrower. The fund got a discounted allocation and the stock closed at $29.60 the next day, so the allocation was worth $0.85 a share. On the 60,000 shares that matter, that is $51,000.
| Measure | Amount |
|---|---|
| Allocation discount on 60,000 shares ($29.60 − $28.75) | 51,000 |
| Profit had the shorts been covered in the market at $29.60 | 74,750 |
| Rule 105 profit measure, covered at the offering price | 125,750 |
The measure is the short-sale gain plus the allocation discount: 74,750 + 51,000. The fund gives up not only what it gained from the offering but the gain on a short position it might have earned anyway. The offering was priced 6.8 per cent below the fund's average short price and 4.5 per cent below its last short sale. That spread, not the next-day discount, is what the measure picks up.
| Offering price | Profit measure |
|---|---|
| $27.50 | 200,750 |
| $28.00 | 170,750 |
| $28.75 | 125,750 |
| $29.50 | 80,750 |
| $30.10 | 44,750 |
Even an offering priced at the fund's last short price leaves a positive figure, because the earlier shorts were sold higher. The timing matters as much as the price:
Business days, not calendar days, and the pricing date, not the announcement date, set the window. A holiday or an offering that prices a day earlier than expected moves the start of the window, which is why the restriction belongs in the order management system rather than in a trader's memory.
Control point: a pre-trade block on indications of interest in any offering for a security the firm has shorted in the last five business days, run across all accounts, is cheaper than any reconstruction afterwards. The post-trade test should recompute the window from the actual pricing time.
The Rule 105 profit measure is the restricted-period short proceeds minus the same shares at the offering price: $125,750 here, more than twice what the allocation was worth. Other matched-trade calculations work differently, for instance Section 16(b) short-swing profits, which pair the lowest purchase with the highest sale. Testing logic for trading and allocation controls is in the free workbook for this case.
Generally the five business days before the offering is priced, or the period from filing to pricing if shorter. Only short sales in that window count. In the illustrative case moving one 20,000 share sale a day earlier, outside the window, cuts the profit measure from $125,750 to $72,750, which is why the window has to be counted from the actual pricing date.
Not by itself. The rule prohibits buying in the offering after a restricted-period short sale, whatever shares are used to close the short, unless a purchase meets all the conditions of the bona fide purchase exception. A fund that covered in the market and still took its allocation would face the same calculation: on the illustrative trades, $125,750 measured from short prices averaging $30.85 against a $28.75 offering price.
Because it is measured against the short sale prices, so it includes the fall in the share price before pricing as well as the discount. In the illustrative case the allocation was worth $51,000 on 60,000 shares at a $29.60 close, but the measure is $125,750: that $51,000 plus $74,750 of short-sale gain.
This article is one calculation from The Private Fund Compliance Officer. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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