Rule 105 Violations — Candlestick Capital and HITE

On February 21 2023, the Securities and Exchange Commission (“Commission” or “SEC”) filed settled complaints against investment advisory firms Candlestick Capital Management LP (“Candlestick”) and Hedge Asset Management LLC (“HITE”) for violating SEC Rule 105 (under Regulation M) when they purchased stock in a public offering after selling short the same stock during a time period when the SEC Rule prohibited those purchases.
Candlestick appears to have identified the Rule 105 violation but did not document the violation in a compliance breach log. Candlestick also did not self‐report the violation to examiners when they conducted a routine exam in 2021.
HITE became aware of its Rule 105 violation but did not take any remedial steps until the Commission commenced its investigation.

Rule 105 of Regulation M is designed to prevent market participants from depressing the price of a secondary offering by short‐selling in a 5‐day window before participating in the secondary offering. The rule provides an exception for a “bona fide purchase” if certain requirements are met.

Candlestick Capital:

Candlestick sold short American Airlines common stock on June 16, 2020. American Airlines filed a prospectus for a secondary offering that was to be priced on June 22, 2020. On June 22, 2020, Candlestick Capital recognized that its short sale of stock fell within the Rule 105 window, and it attempted to purchase American Airlines shares on the open market in a failed attempt to effectuate a “bona fide purchase”. However, the purchase occurred too late, and Candlestick was in violation of Rule 105 after it received an allocation in American Airline’s secondary offering.
Candlestick realized that it had violated Rule 105 on June 22, 2020 but did not report the issue, did not document it in a compliance violations log or anywhere in its books and records, and did not conduct a review to identify other possible violations. Candlestick did not take any remedial steps before being examined.
Candlestick appears to not have reported the violation to examiners even though the violation likely fell within the examination period if the exam took place in 2021, per the press release.

HITE:

On May 7, 2021, HITE sold short shares of Pioneer Natural Resources and then participated in a secondary offering priced on May 10, 2021.
HITE did not have any formal written policies regarding Rule 105, and the CCO, who approved participation in all secondary offerings, approved the participation because he mistakenly thought that Rule 105 did not apply.

The SEC and Rule 105: The Commission has a history of bringing Rule 105 cases ‐‐ more than three dozen in the previous decade. Rule 105 is a straightforward regulation that is detectable through analytics and surveillance, two capabilities that have steadily improved at the Commission. It is likely that the Commission will continue to pursue Rule 105 cases, so even unintentional violations of the rule should be promptly remediated.
Recognizing and Remediating Mistakes: Both Candlestick and HITE eventually realized that they had violated Rule 105 but neither one took any remedial steps until it was too late. While remedial steps may not always solve securities law violations, the lack of such steps will likely exacerbate a violation and motivate Commission staff to pursue remedies for violations that might otherwise have been viewed as technical.
Mistakes and Compliance Culture: There are no compliance programs of any size or complexity where mistakes have not been made. Even so, we have observed that some corporate cultures are less tolerant of mistakes than others. In our view, this creates risk because it could incentivize employees to fail to recognize and flag their own mistakes, which reticence could end up transforming small problems into big ones.