What is Regulation M?

John Lister
John Lister
Man climbing a rope
Man climbing a rope

Regulation M can refer to two different legal regulations, both of which may be of relevance to investors. One is a set of rules adopted by the Securities and Exchange Commission in 1996 covering the behavior of a variety of people involved in securities dealing. The other is an IRS regulation affecting regulated investment companies.

The SEC version of regulation M includes rules covering five classes of people. Rule 101 covers underwriters and broker-dealers during major stock issues. Depending on the circumstances it temporarily restricts or permanently bans a person from for buying or persuading others to buy the stock that he or she are dealing with. Rule 102 puts similar restrictions on others involved in issuing the stocks, though does allow publicity about the fact that the stock is going on sale.

Rule 103 allows those involves in Nasdaq securities a degree of exemption from rule 101. This exemption requires the affected broker-dealers to be "passive market makers." This means any behavior should not unduly influence the market price. This is governed by a series of restrictions on how any stocks the broker-dealer is allowed to buy on any one day, and a rule that means he cannot bid a higher price to buy stocks than the highest bid being made at the time by any independent trader.

Rule 104 of regulation M bars people from working with others to unfairly stabilize the price of a security. The general principle of the rule is that such stabilizing bids are only usually allowed to prevent or reverse a decline in a security's price, rather than to intentionally raise the price. Even where such bids are allowed, the person must give priority to bids from independent traders who are not involved in the stabilizing agreement.

Rule 105 restricts short selling of a security just before the price of a new issue of the security is announced. Short selling involves borrowing stocks and selling them immediately, then buying them back at a later time to return them to the lender. Somebody carrying out short selling will make money if the stock price falls, rather than rises.

A second rule known as regulation M is an IRS rule covering regulated investment companies, better known as mutual trusts. The rule specifically allows the company to pass on all dividends, capital gains, and interest on its investments to the individual investors, who are then responsible for the relevant taxes. The purpose of the rule is to avoid the company paying taxes on these gains and the investors then paying tax on what was left over.

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