US PRIVATE SECURITIES

Institutional or sector buyers eager to acquire a stake in companies that are already public have Over the historically been active Pipe , although many are subject to limits on their restricted holdings. Now, given the abbreviated Rule 144 holding period, many show renewed worst of it interest in Pipes. On balance, SEC scrutiny of the trading The US courts have reached the wrong conclusions in activities of hedge fund investors in Pipes has limited abusive practices. The SEC has recent Pipe cases. The SEC has been unable to help them prosecuted many Pipe cases, in which defendants traded on inside information or engaged in manipulative trading practices. The North Carolina court has made Pipe transactions. But the traditional Pipe is a information that these cases provide is high-school Latin relevant again. specific form of private placement made to straightforward. It underscores the need for In a Pipe (Private Investment in selected accredited or institutional investors. issuers, financial intermediaries acting as Pipe Private Equity) case, SEC v Investors commit to purchase a specified placement agents and investors to take care in MAangan, the judge dismissed the SEC’s number of securities (usually ) connection with Pipes and other hybrid (Securities and Exchange Commission’s) from an issuer at a fixed price not subject to financings. Throughout these cases, the SEC charge that defendants had engaged in the market price adjustments or fluctuating ratios. reiterated its support for traditional Pipes. All unregistered sale of securities. The judge The issuer undertakes to file a registration of this should bode well for the Pipe market. In accused the SEC of a logical causal fallacy, in a statement with the SEC covering the investors’ fact, given their troubled past, Pipes may never post hoc ergo propter hoc edict (“after this, resale of the restricted securities sold in the have had as bright a future. It may be the case therefore because of this”). This decision was Pipe. A Pipe may involve newly issued issuer that Mangan, similar court decisions on the first in a series of well-publicised, and (primary) shares, shares held by selling Section 5 issues and the SEC’s response, will therefore embarrassing defeats for the SEC in stockholders (secondary shares), or a lead to an increase in the use of Pipes. its Pipes enforcement initiative. combination of the two. In the case of primary The Mangan case also raised several (issuer) shares, the issuer relies on Section 4.2 A brief history questions about selling, which the SEC and/or Regulation D exemptions from the Pipes have largely overcome their troubled has promised to resolve by providing guidance Section 5 registration requirements. Disclosure past. Many of the issues that surfaced in recent on naked shorting. In response to SEC of the Pipe occurs only after the issuer receives enforcement actions are not new. A brief requests about whether additional regulatory definitive purchase commitments, reducing review of the SEC’s guidance may give helpful guidance on hedging would help, the market impact of the financing and the risk context to these events. They are consistent, commentators in the past have universally of deal failure. but for the confusion generated by the courts’ agreed that less is more. Practitioners have The credit crisis and resulting market views on potential Section 5 violations arising understood the SEC’s views and its guidance have made Pipe transactions an even from shorting activities. on Section 5 of the Securities Act and hedging more attractive financing for issuers of In the mid-nineties, the SEC focused on the restricted securities. The consensus, though, all sizes. Issuers appreciate the targeted private placement aspect of the Pipe – was was that the market was far better served by marketing of a Pipe, which allows them to test there a bona fide private placement? Many not having more specific guidelines relating to the waters without committing publicly to a Pipes were completed at substantial discounts risk mitigation techniques. financing transaction. Fully marketed follow- to the trading price of the issuer’s common on offerings frequently subject an issuer’s stock stock; many Pipe investors flipped their Pipe More attractive to short selling. Of course, in a Pipe an issuer shares immediately after the Pipe closing. The This comes at an interesting time for the Pipes sells its securities for less than the market price SEC questioned whether the investment market. Pipes have become an increasingly of the issuer’s securities, given that the issuer is representations made by Pipe investors in the important hybrid-financing alternative. In selling restricted securities. This discount purchase agreements were accurate and made 2006 and 2007 Pipes raised about $36 billion compensates investors for the illiquidity in good faith. In 1999, during the ascendancy and $50 billion respectively. The term Pipe associated with holding restricted securities. of death-spiral and convertible Pipe generically refers to any private placement of a Recent SEC changes shortening the Rule 144 transactions, the SEC focused on whether Pipe public company’s securities. Several capital- holding period for restricted securities have investors bore market risk for the restricted raising techniques involving private financing reduced this liquidity discount, thus securities purchased. The SEC objected to by an already public company are referred to as improving Pipe pricing for issuers. many of the adjustment features in these deals. Specifically, the SEC viewed variable-price provisions as a mitigation of market risk, which challenged the availability of the original The decision was the first in a series of private-placement exemption in the Pipes. “ Guidance in the form of SEC staff telephone well-publicised, and therefore embarrassing, interpretations addressed these concerns. The SEC raised similar issues in connection defeats for the SEC in its Pipes with equity-line transactions structured as enforcement initiative private placements. The put/call features of ” equity lines mitigated the market risk for equity-line investors. Eventually in 2001 the

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SEC required that disclosure be included in avoid bringing about a premature disclosure, the registration statements to identify potential the placement agent must implement violations of Section 5 regarding the private- procedures to ensure that potential investors “They appreciate placement portion of these transactions. The are aware of the confidential nature of the SEC concluded that equity lines were indirect financing discussions. Such investors do not how difficult it may primary offerings. As a result the SEC required normally receive material non-public that equity line investors be identified as information about the issuer or its business. prove to create underwriters. Marketing materials are limited to an issuer’s regulation that is More recently, in 2006, the SEC took the Exchange Act or other public filings. But the that for small-cap issuers a resale fact that the issuer is considering a financing intelligent, registration statement might not be available in may itself be material non-public information. connection with the registration of securities Investors contacted by a placement agent principled, and originally sold to investors in Pipe deals. Small- about a Pipe will have received news of a cap issuers were not eligible to use short-form potential financing. They will be asked to keep unlikely to do registration statements on a primary basis this material non-public information before the amendments to the short-form confidential. unintended harm” (Form S-3) registration statement. The SEC The SEC found that many hedge fund commented that a resale registration statement investors that were Pipe offerees or Pipe might not be available if the issuer had sold a investors traded in the securities of the Pipe undertaking in a purchase agreement. In SEC disproportionately large number of securities issuer before the transaction was announced. v Lyon, relating to the Gryphon funds, many in a Pipe (relative to the issuer’s pre-transaction Trading based on this non-public information, questions were raised about how the placement total ). It asked whether the including entering into hedging transactions in agent had informed the funds of the purported secondary offering could be a the issuer’s securities, violates the securities confidential nature of the information they primary offering. As a guide, the SEC laws. Interestingly, defendants in Mangan were receiving. For example, the defendants indicated that it would subject to closer questioned whether news of the financing was received an email from a placement agent scrutiny Pipe transactions resulting in the itself “material.” Once a Pipe has been containing the assertion that acceptance of the issuance of shares of more than 33% of the announced, either through a press release or in appended documents constituted an issuer’s pre-transaction outstanding shares. a Form 8-K, investors no longer have any acknowledgement that they were receiving The SEC also published its proposal for material non-public information, assuming restricted non-public information. The Rule 144 amendments. The proposal they have no other special knowledge. defendants alleged that this sort of suggested tolling the holding period for communication did not create a duty of restricted securities for up to six months if a Confidential confidence. The case is as a reminder for security holder had entered into a risk To prevent premature disclosure of a Pipe and placement agents of the importance of mitigating transaction for restricted securities for a Pipe issuer to comply with Regulation appropriate compliance procedures. They during that period (if the holder had a short FD, an issuer must ensure that before the must obtain express confidentiality position or had entered into a put-equivalent placement agent shares the issuer’s name or undertakings in connection with Pipes. position). The proposed reintroduction of other details with potential investors, the tolling was withdrawn from the final Rule 144 promises that it will keep such Tensions amendments. But it again signalled the SEC’s information confidential and refrain from Pipe investors make representations and concern about risk mitigation-transactions effecting transactions in the issuer’s stock. warranties for the issuer’s benefit. These regarding restricted securities. Under Regulation FD, an issuer is owed a duty include proof that investor is an accredited of confidence from its agents (such as investor, confirmation that the issuer delivered Insider trading placement agents), and from other participants the materials connected with the offering, a During the SEC’s 2005 and 2006 review of in the Pipe process from whom it has obtained confidentiality undertaking (discussed above), hedge fund activities, hedge fund trading in a confidentiality undertaking. and an investment representation. Pipe close proximity to Pipes caught its attention. In Placement agents often enter into investors give each investor an opportunity to 2007, the Enforcement Division set up a transaction-specific confidentiality or omnibus conduct its own investigation regarding the special unit to focus on insider trading by confidentiality agreements. These agreements issuer and its business. The investment hedge funds. The SEC found many hedge require potential investors to confirm that they representation states that the investor is funds traded before news of a Pipe was made will treat as confidential the information they purchasing the securities without a view to public or while in possession of non-public receive relating to possible Pipe financings; distribution. It is essential to a good private information relating to Pipe issuers. The SEC they must confirm that they understand the placement. brought successful actions charging hedge federal securities law obligations about the Recent Pipe cases have shown tensions in funds and investment bankers with insider need to keep such information confidential connection with the investment intent trading and manipulative trading practices. and to refrain from trading in the issuer’s stock representation. The divide between straight These included actions against Guillaume until that information becomes public. Other private placements and public offerings has Pollet, Hilary Shane, Galleon Management, placement agents rely on scripts to pre-qualify narrowed because of the proliferation of hybrid Langley Partners, and Deephaven Capital potential investors and receive oral transactions such as Pipes. Investment Management. In recent cases, the SEC has undertakings that are later confirmed in representations must be reconciled with the successfully pursued allegations relating to writing. almost immediate availability of a resale insider trading violations. This raises questions about Pipe offerees that registration statement. An issuer contemplating a Pipe will not ultimately do not participate in the Pipe and The SEC has explained that investors in a disclose the potential financing publicly. To do not reaffirm their confidentiality private placement transaction completed in www.iflr.com IFLR/June 2008 3 US PRIVATE SECURITIES

prohibiting investors from trading in the staff considered the following: issuer’s securities during particular periods. An issuer filed a Form S-3 registration Investors that violate the investment statement for a secondary offering of common “The SEC has representation by disposing of the securities stock, which is not yet effective. One of the prematurely may be deemed statutory selling shareholders wanted to do a short sale of announced that it underwriters. As a result, they may be unable common stock “against the box” and cover the to rely on the Section 4.1 resale exemption. Put short sale with registered shares after the will provide another way, investors that engage in short effective date. regulatory guidance sales of publicly traded shares while purchasing The SEC concluded that the short sale Pipe shares are acting as underwriters in the could not be made before the registration on shorting. To contemplated public distribution of the issuer’s statement becomes effective because shares that stock, not as bona fide investors in a private are the subject of the short sale are deemed to practitioners, it was placement. be sold at the time the sale is made. Sale of the shares before the effective date of the always clear Violations registration statement would violate Section 5. ” In several recent cases, including Mangan, Lyon and SEC v Berlacher, the SEC has alleged that A logical fallacy the defendants engaged in unregistered sales of The courts seemed to ignore the fact that when reliance on the Section 4.2 exemption or Rule securities in violation of Section 5. In each case defendants shorted shares, they introduced 152 must bear the risk of holding the restricted the defendants purchased securities in a Pipe issuer shares into the market. At the time that securities they committed to purchase before and shorted the securities before the they shorted – the first leg of the new the resale registration statement was filed. In a declaration of effectiveness of the resale transaction – the defendants held an economic traditional Pipe, investors commit to purchase registration statement. After the resale interest only in restricted securities. The courts a specified number of securities at a fixed price, registration statement was declared effective, did not consider the character of the short sale. bearing price risk as soon as they enter into a the defendants covered their short positions Was the short sale exempt from registration? definitive purchase agreement. The purchase with the Pipe shares. Was the short sale an indirect sale of the price cannot be contingent on the market price The SEC argued that through the initial restricted security? On the second leg of the of the securities at the time of effectiveness of shorting, the defendants had sold securities, transaction (the short-covering), the the registration statement. violating Section 5. It further argued that the defendants used the shares received in After the public announcement of a Pipe, an shares ultimately used to cover the short sale connection with the Pipe transaction. The investor may mitigate its market risk by were sold when the underlying short sale was courts did not consider the fact that the entering into hedging transactions. Once a made – which occurred before the resale registration statement in a Pipe was a resale Pipe is announced, the issuer’s stock price often registration statement was declared effective. In registration; it covered resales by the Pipe trades down. By shorting the stock, Pipe these cases, the defendants could have used a investor of the restricted securities purchased in purchasers try to lock in the differential double-print approach, which the SEC has the Pipe. Resale registration covers a particular between the Pipe purchase price and the later agreed is permissible. They could have covered transaction or offering, not particular stock price. their short positions with securities purchased securities. By using the Pipe shares for the short in the open market, provided that the initial covering, the defendants created a link back to Lack of integrity sale and the open market purchase(s) are not the initial short sale. An incipient Section 5 These hedging transactions raise concerns linked. violation became an actual Section 5 violation. about the integrity of the investors’ investment The courts dismissed the Section 5 claims. A thorough review of the judicial decisions representations. Is it possible to reconcile short They struggled with the metaphysics of the and associated pleadings suggests that the sales in connection with a Pipe with an SEC’s shorting analysis and concluded that courts lacked context relating to the dynamics investment intent representation? In SEC v there was no statutory support for the SEC’s of shorting and the surrounding issues. It also Lyon, the SEC alleged that the defendants view. Effectively, the courts concluded that a suggests that the SEC litigation effort was committed fraud based on affirmative short sale is a sale of the security, the short sale ineffective in providing the context and in misrepresentations about their investment is not related to the short-covering transaction, explaining the issues. The defendants and their representations. The defendants falsely and, barring manipulative trading practices, counsel see these decisions as a victory. We represented their investment intent to the Pipe when and how the investor covers the short view the Mangan and similar verdicts as issuers, when they planned to sell short sale is irrelevant. In rejecting the SEC’s resulting in their own post hoc ergo propter hoc (effecting a “distribution”) and cover with Pipe arguments, the courts were dismissive. In fact, logical fallacy. The SEC has announced that it shares. the SEC has long taken the view that a hedging will provide regulatory guidance on shorting to Little or no SEC guidance exists regarding transaction relating to a restricted stock address the confusion on the scope of which transactions are appropriate and which position may constitute a Section 5 violation. permissible activities. To practitioners, it was are not. Issuers have tried to address these If a short sale is made before the effective always clear. concerns by bolstering investment date of a registration statement of securities of The US capital markets participants await representations taking a number of different the same class as those sold short and those the SEC guidance anxiously. They appreciate approaches: prohibiting any hedging activities; short sales are covered with shares obtained in how difficult it may prove to create regulation obtaining evidence that the investors do not the registered offering, the SEC regards the that is intelligent, principled, and unlikely to have a net-short position in the issuer’s initial short sale as a Section 5 violation. The do unintended harm. In the post-Sarbanes- securities when the purchase agreement is SEC has expressed its views in several releases, Oxley world, these are reasonable concerns. executed; proscribing certain hedging and in the staff’s telephone interpretations. In By Anna T Pinedo and James R Tanenbaum of transactions before conversion periods; or one of its telephone interpretations, the SEC Morrison & Foerster

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