Down But Not Out: The SEC Will Rise From The PIPE AshesApril 2008 Small Business Securities Newsletter
As seen in the Small Business Securities Newsletter. Published by the Securities Practice Group to provide timely and useful information to CEOs, CFOs, and General Counsel
The Securities and Exchange Commission’s (SEC) recent prosecution of Securities Act of 1933 (Securities Act) Section 5 cases in PIPE (private equity investment in public equity) transactions hit a brick wall in 2007 and early 2008.
PIPE transactions – a prevalent structure used in financing for smaller public companies – generally involve investments by hedge funds and sophisticated investors in restricted securities of public companies. For many years, the SEC has been scrutinizing these transactions as they believe the structure of certain deals and the trading practices of certain investors in these deals hurt rather than help smaller public companies. The SEC has brought several enforcement cases against traders and hedge funds involved in the PIPE market, alleging violations of the anti-fraud provisions of the federal securities laws and engaging in the sale of unregistered securities in violation of Section 5 of the Securities Act.
In two recent federal district court cases, the SEC’s Securities Act Section 5 claims have spiraled down in flames. In both cases, the SEC advanced a novel argument. The SEC argued that, in many PIPE transactions, investors engaged in short sales of an issuer’s stock prior to the effective date of the registration statement covering the public resale of the restricted shares issued in the PIPE transaction. After the registration is declared effective, the investors cover their short positions with the newly registered shares issued in the PIPE transaction. The SEC argued that the short sales by PIPE investors were, in reality, public sales of unregistered securities in violation of Securities Act Section 5.
The first broadside against the SEC was leveled by a North Carolina federal district court judge in SEC v. Mangan. In Mangan, the court found that the SEC was advancing a “creative liability theory” and chastised the SEC for bringing these claims because, in the court’s opinion, the Mangan investor did not cover his short sales with unregistered securities. In fact, the court stated that the shares used to cover the short sales were registered, and reasoned that, if the Mangan investor could not cover the short sales with securities pursuant to a registration statement, the PIPE investor would have been required to re-enter the market to cover those short positions.
Similarly, in early 2008, a New York federal district court, in SEC v. Lyon, granted a PIPE investor’s motion to dismiss Securities Act Section 5 claims brought by the SEC. In the Lyon case, the court also offered very little support for the SEC’s arguments, and claimed that the SEC position was based upon an “inherent logical implausibility.” The court also questioned the SEC’s approach in that it did not advance the purpose of Securities Act Section 5 regulation.
However, all is not lost for the SEC. Both the Mangan and Lyon courts were reluctant to dismiss the insider trader claims brought by the SEC against the investor-defendants, because the SEC had made plausible arguments relating to whether these PIPE investors made these short sales based upon inside information. One court noted that these claims were factual in nature, and that there were confidentiality restrictions contained in the PIPE transaction documents that may have been violated. The Mangan court was, nonetheless, swayed by the defendants’ arguments that, if the disclosure did not significantly affect the stock price, then the disclosure was immaterial as a matter of law. Despite this fact, the Mangan court denied the motion to dismiss the insider trading claims.
In sum, although the SEC was turned back on the Securities Act Section 5 claims, short sales and other trading activity by PIPE investors prior to the time such deals are announced or such shares are registered for sale to the public still pose substantial risk of insider trading liability. Further, the SEC has made public statements, after these court rulings, that it will continue to view a short sale covered by shares issued in PIPE transactions as a violation of Securities Act Section 5, and is considering rule making in this area.