Client Alert: Ruling on PIPE Transactions

01.22.2008

On January 2, 2008, the U.S. District Court for the Southern District of New York ruled in SEC v. Lyon, No. 06-Civ-14338, that investors could use restricted shares purchased in a PIPE transaction to cover a short position without violating Section 5 of the Securities Act of 1933.  The Court did warn, though, that such conduct could constitute unlawful insider trading if the participant in the PIPE transaction had a confidential relationship with the issuer of the PIPE.

PIPE (private investment in public equity) transactions generally involve the sale of securities of a public company to qualified investors in a confidential nonpublic offering.  Such securities are deemed restricted, and cannot be publicly traded until registered under the Securities Act.

Prior to this case, in a number of recent enforcement actions the SEC has argued that a short sale violates Section 5 of the Securities Act of 1933 when a defendant (1) buys restricted PIPE securities, (2) then shorts the issuer’s shares before the registration statement becomes effective, and (3) once the PIPE registration becomes effective, uses the PIPE securities to cover their short position.  According to the SEC, by taking a short position before the registration statement becomes effective, defendants effectively sell the unregistered PIPE securities of the issuer that they anticipate will become registered.

In one of the first written court opinions to address the issue, Judge Sidney Stein described the SEC’s position that shorting the issuer’s publicly traded shares constituted a sale of the as-yet unregistered PIPE securities as an “inherent illogical implausibility.”  In a sharply worded opinion, the Court found the SEC’s “characterization of a short sale inaccurate and not reflective of what occurs in the market…from the Court’s perspective, a short sale of a security constitutes a sale of that security.”  Furthermore, the Court criticized the Commission for quoting “selectively—and in the Court’s view misleadingly” from a series of administrative releases in support of its position.  And finally, the Court concluded that the defendants, a series of hedge funds and its chief investment officer, had not violated the antifraud provisions of the securities law by taking the short position while signing agreements representing that they were purchasing the PIPE securities in compliance with Section 5 of the Securities Act.

While soundly rejecting the SEC’s position with regard to the application of Section 5, the Court found that an insider trading claim was appropriate where a participant in the PIPE transaction has a confidential relationship with the issuer.  According to the Court, advance knowledge of a PIPE offering allows an investor to trade on that knowledge with a clear advantage over the general investing public.  As evidence of this, the Court noted that the price of a PIPE issuer’s publicly traded stock typically declines once the PIPE transaction is publicly announced.  The Court also observed that PIPE issuers frequently combat the risk that prospective PIPE investors will trade on nonpublic information by imposing duties on prospective investors to refrain from trading on the information before it becomes public. 

Although the Court in Lyon allowed the insider trading claims to proceed, it also suggested that the case ultimately could turn on whether defendants had actually agreed to maintain the confidentiality of the PIPE transaction, or whether it was customary practice among participants to be bound by the confidentiality provisions included in the offering memoranda.

It is likely that the SEC Enforcement Staff will continue to advance the position that securities ultimately used to cover a short sale are deemed to have been sold when the underlying short sale was made.  The SEC already has filed a motion to amend the Court’s conclusion that the Commission’s briefing cited misleadingly to its prior administrative releases.  However, this “win” for the defendants on the Section 5 theory may make it harder for the SEC to reach settlements in similar cases.  In addition, the SEC Enforcement Staff will most certainly proceed with the insider trading portion of the case and will likely appeal the ruling in Lyon on the Section 5 theory.

If you have questions about this Client Alert please contact the Heller Ehrman attorney with whom you normally work or any of the attorneys listed below:

Sara Brody, sara.brody@hellerehrman.com, +1 (415) 772-6475

Nora L. Gibson, nora.gibson@hellerehrman.com, +1 (415) 772-6835

Lawrence J. Zweifach, lawrence.zweifach@hellerehrman.com, +1 (212) 847-8762

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