In a PIPE, accredited investors (usually hedge funds) acquire company securities in a private offering as a discount to the securities' market value. The issuer undertakes to register the shares with the SEC, usually within 90 to 120 days of the private offering closing. My earlier post reviewed the benefits of PIPEs to issuers and investors.
A June 9, 2007 article by William K. Sjostrom, Jr. of Northern Kentucky University Law School entitled simply "PIPEs" (here) takes a closer look at PIPEs financing, reviews why hedge funds invest in these offerings, examines the regulatory issues (including the SEC enforcement actions) in which hedge funds get involved, and critiques the SEC's current regulatory stance on PIPEs.
The article emphasizes that PIPEs are an important funding source for small companies, Approximately 90% of 2006 PIPEs transactions involved companies with market caps below $250 million, generally because they have no financing alternatives. More than 84% of PIPEs issuers have negative operating cash flows and a majority would run out of cash without the PIPE.
Under the circumstances, it might well be asked who would invest in a PIPE; the answer is hedge funds.
Hedge funds constitute nearly 80% of the investors in microcap PIPEs, and the hedge funds invest in PIPEs because of the returns they can achieve. By using a strategy whereby they sell short the issuer's common stock promptly after the PIPE deal is disclosed, they are able to lock in the deal purchase discount (which, all in, ranges from 14.3% to 34.7%), as either a rise or fall in the issuer's share price after the PIPE would cause an increase in value of either the long or short position and a decrease in the complementary position.
To execute this strategy, the hedge fund must be able to borrow the shares to cover their short position. But since the stock of many PIPEs issuers is very thinly traded, the hedge fund may not have shares to cover the short position - a so-called "naked short," which while not illegal per se, may constitute illegal stock manipulation. (An SEC enforcement action against a hedge fund investor that engaged in a naked short in connection with a PIPE transaction can be found here.) A June 14, 2007 New York Times article about naked short selling can be found here.
Because of the popularity of PIPEs investments, as well as the fact that (as Professor Sjostrom puts it) some hedge funds "routinely push the legal envelope with their trading strategies," the SEC has stepped up its enforcement activities in this area and "has brought at least eleven enforcement actions relating to PIPEs deals."
The SEC has, for example, alleged that hedge funds have engaged in illegal insider trading by shorting the issuer companies' stock prior to the announcement of the PIPE transaction (refer here for a case example) and that the hedge fund investor has violated Section 5 of the Securities Act of 1933 by using the shares the hedge fund bought in the PIPE private placement to cover their open short position (refer here for a case example). The SEC's position is that the hedge fund should use shares purchased on the open market to cover the open short position. (A prior D & O Diary post discussing these enforcement actions can be found here.)
The SEC's regulatory response to tighten its control over PIPEs has been to declare that PIPEs deals involving more than 33% of an "issuer's float" constitutes a "primary" offering, which would render investors (such as hedge funds) in a PIPE of more than 33% of float into "underwriters" and therefore subject them to potential liability under Section 11 of the '33 Act. A December 27, 2006 Wall Street Journal article discussing the SEC's position can be found here (subscription required). The SEC's position was stated more recently in a January 27, 2007 speech (summarized here) by David Lynn, at the time the SEC's Chief Counsel of the Division of Corporate Finance. (Lynn recently left the SEC and joined the CorporateCounsel.net team, refer here.)
According to another recent article (here) discussing the SEC's new cap and commenting on the possibility that under the SEC's new guidelines PIPEs investors might take on underwriter liability exposure under Section 11,
Most PIPE investors are unwilling to ... accept such liability. PIPE investors who might be willing to accept liability as underwriters certainly would require the full panoply of the underwriter's traditional protections: representations and warranties, indemnity, conflict letters, opinions, and extensive due diligence. The speed and efficiency associated with PIPEs would be lost.Professor Sjostrom's article points out that this constraint effectively puts a cap on the size of PIPEs deals, and that the lower the dollar value of a company's public float, the less money it will be able to raise through a PIPE transaction. As the author notes, the SEC's cap "hits small companies the hardest, the very companies that have few, if any, other financing options." The author calls on the SEC to take into account the effect its regulation has on the PIPEs financing market, "considering that it represents the sole financing option for many small public companies." The author concludes that "a more measured and transparent SEC approach to PIPE regulation is in order."
A very good and detailed (albeit more technical) discussion of the regulatory issues, including the practical implications of the SEC's screening process under the new guidelines, can be found here.
As I discussed in my prior post, PIPEs are likely to remain an important part of the financial landscape, in part because, as Professor Sjostrom argues, companies that engage in PIPEs often have no other financing alternatives. There are, as I previously pointed out, some PIPEs elements that characterize riskier PIPEs deals, but a transaction should not be suspect simply because it is a PIPE. That is, a PIPE should be viewed , and, as Professor Sjostrom argues, regulated, with a more "measured" approach, and the focus should be on the riskier deals (such as the so-called "structured PIPEs") that represent the relatively greater risk to issuers and investors.
Do Activist Investors Hurt Bondholders?: While I'm on the subject of hedge funds, I should reference the June 13, 2007 CFO.com article (here) about a recent Moody's study showing that demands of "short-term shareholder activists" (read: hedge funds) are "generally negative for credit quality." This can be caused by the actions responsive to activist investor pressures, such as the company's sale of significant assets with the proceeds passed to shareholders; increases in dividends or share buybacks; or a more leveraged financial strategy. These activities have "the potential to change the company's credit profile over the short to medium term." The short-term activists also "distract management from running the business to deal with their demand, eating up corporate resources and wealth."
There are, however, a "minority of cases" where following activist intervention "a company embarks on a more focused strategy...and makes significant improvement to practices, including disciplined capital allocation."
A Full Disclosure Endnote: The full name of the Northern Kentucky University Law School is the Salmon P. Chase College of Law. The school's name refers to the 19th century Ohio Senator and Governor who served in Lincoln's cabinet as Secretary of the Treasury and who also served as Chief Justice of the United States Supreme Court from 1864 until his death in 1873 (refer here for more detail). While serving as Chief Justice, Chase presided at the impeachment trial of Andrew Johnson. In addition to the Law School, Chase Manhattan Bank (now part of JP Morgan Chase) is also named after the former Chief Justice.