SEC Claim Against Hedge Fund Manager for Illegal PIPES Transactions Fails

In an SEC enforcement action, a federal judge has ruled that a hedge fund manager and the managed funds did not violate Securities Act registration provisions in connection with PIPES transactions. The SEC did not state a plausible claim against the fund manager and the funds for distributing unregistered securities or for fraud arising from the distribution of unregistered securities. These claims were dismissed with prejudice. However, an insider trading claim against the fund manager and the funds was permitted to proceed. (SEC v. Lyon, et al, SD NY, 06 Civ. 14338, Jan 2, 2008).

The SEC alleged the unlawful distribution of unregistered securities based on the assumption that the shares ultimately used to cover a short sale are deemed to have been sold when the underlying short sale was made The Court finds that assumption Unwarranted

The fund manager and the funds participated in at least 36 PIPE transactions. PIPE securities are generally issued pursuant to a nonpublic offering exemption from the registration requirements of the Securities Act that allows the shares to be sold privately. In order to ensure the applicability of one of these exemptions, the PIPE issuers require investors to pledge that they will refrain from immediately redistributing their PIPE shares to the public.

Thus, each PIPE securities purchase agreement contained a provision requiring investors to represent that they were purchasing the securities for their own account and without any present intention of distributing the securities. The hedge fund manager signed these securities purchase agreements in connection with the PIPE transactions.

Upon the public announcement of the issuance of restricted shares in a PIPE offering, the price of the PIPE issuer’s publicly traded stock generally declines. Once they are issued, PIPE shares are considered restricted and cannot be publicly traded until the issuer files and the SEC declares effective a resale registration statement. In the interim between the acquisition of restricted shares and the effective date of corresponding resale statements, PIPE investors often hedge their investments by selling short the PIPE issuer’s publicly traded securities.

The funds hedged all but one of their PIPE investments by executing short sales that fully hedged or hedged as much as possible their PIPE positions. When the funds shorted the PIPE issuers’ publicly traded stock, no resale registration statement was in effect for the corresponding PIPE shares and no registration exemption applied to those shares. In order to cover their short positions, the funds waited until the SEC declared a PIPE resale registration statement effective and then used their formerly restricted PIPE shares to close out their short positions.

The SEC said that the fund manager and the funds made these representations falsely because they planned to distribute the PIPE securities through short selling and covering with the PIPE shares in violation of section 5.

Rejecting the SEC’s position, the court noted that the funds’ representations were not false because their short sales did not constitute a distribution under the Securities Act, and thus they did not misrepresent their investment intentions. The short sales did not violate section 5, ruled the court, and thus the funds’ alleged intention to short the PIPE issuers’ publicly traded securities did not undermine their pledge of compliance with
section 5.

under the SEC’s theory, defendants unlawfully sold PIPE shares to the public via an unregistered three-step distribution. First, defendants bought PIPE shares issued by publicly traded companies that were restricted from being sold publicly. Next, they sold short the PIPE issuers’ public shares prior to the effective date of a resale registration statement for the PIPE shares. Finally, after the resale registration statements for the PIPE shares became effective, defendants “covered” their short positions with those PIPE shares.

The delivery of once-restricted PIPE shares to close a short position did not convert the
underlying short sale into a sale of PIPE shares, reasoned the court, since securities used to close a short position are not sold or offered for sale at the time when a short sales is made. This holding effectively rejects the SEC’s contention that PIPE shares were sold or offered for sale by the funds when they transacted their short sales in favor of the funds’ position that publicly traded shares were offered and sold through those trades.

With regard to the insider trading claim, the SEC stated a plausible claim that the hedge fund manager and the funds were bound by a duty of confidentiality based on a confidential relationship with four PIPE issuers. The SEC alleged that a purchase agreement and offering materials required investors to keep the information conveyed in connection with the offerings confidential.