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SEC Claim Against Hedge Fund Manager for PIPEs Registration Violation Fails

In an SEC enforcement action, a federal judge has ruled that a hedge fund manager and the managed funds did not violate 1933 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, January 2, 2008).

The SEC alleged that the distribution of unregistered securities was unlawful based on the assumption that the shares ultimately used to cover a short sale were deemed to have been sold when the underlying short sale was made. The court found that assumption unwarranted.

The fund manager and the funds participated in at least 36 PIPEs transactions. PIPEs securities are generally issued pursuant to a nonpublic offering exemption from the registration requirements of the 1933 Act that allows the shares to be sold privately. In order to ensure the applicability of one of these exemptions, the PIPEs issuers require investors to pledge that they will refrain from immediately redistributing their PIPEs shares to the public.

Each PIPEs 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 PIPEs transactions.

Once issued, PIPEs 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 the restricted shares and the effective date of the corresponding resale statements, PIPEs investors often hedge their investments by selling short the PIPEs issuer's publicly traded securities.

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

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

The court rejected the SEC's position and noted that the funds' representations were not false because their short sales did not constitute a distribution under the 1933 Act, so they did not misrepresent their investment intentions. The short sales did not violate section 5, according to the court, so the funds' alleged intention to short the PIPEs issuers' publicly traded securities did not undermine their pledge of compliance with section 5.

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

The delivery of once-restricted PIPEs shares to close a short position did not convert the underlying short sale into a sale of PIPE shares, according to the court, since securities used to close a short position are not sold or offered for sale at the time when a short sale is made. This holding effectively rejects the SEC's contention that PIPEs 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 PIPEs issuers. The SEC alleged that a purchase agreement and offering materials required investors to keep the information conveyed in connection with the offerings confidential.