Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In an earlier post (here), I examined the risk characteristics surrounding Private Investment in Public Equity (PIPEs) financing, and argued that PIPEs are an increasingly important part of small public company financing, and that companies should not be viewed as suspect merely because they have resorted to PIPEs financing. Since the time of my prior post, PIPEs have continued to increase in importance. According to CFO.com (here), in the first quarter of 2007 alone, there were 302 PIPEs transactions totaling $10.92 billion in equity raised, which represents a 48 percent increase over the amount raised in the first quarter of 2006.

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.

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New Wave of Options Lawsuits?: Regular readers know that The D & O Diary has been tracking options backdating lawsuits (here). A December 20, 2006 article on Law.com entitled "McAfee Employees' Suit Reveals New Options Dynamic" (here) raised the question whether a breach of contract action brought by the employees of McAfee represents the opening salvo in a "new wave" of options backdating related litigation.

Seven McAfee employees have alleged they were "cheated" out of $2 million because the company did not permit them to exercise stock options that then expired during the company's self-imposed blackout. The company imposed the blackout during a delay in the filing of its financial statements while it investigated possible options backdating. The blackout was imposed to prevent stock transactions that might later give rise to insider trading allegations. Employees whose shares expire during a blackout period are out of luck unless the company extends the expiration dates. McAfee apparently declined to extend the expiration date for plaintiffs' options, all of whom had or have left the company. The plaintiffs allege that the company is "unfairly penalizing them for the accounting misdeeds of management." The article quotes a plaintiffs' lawyer who said that she "expects many suits similar to the McAfee action to be filed over the next few months."

The breach of contract action is merely the latest options backdating related problem at McAfee. Press reports (here) recently suggested that Kent Roberts, McAfee's former general counsel, may be indicted by federal prosecutors in coming weeks on charges relating to stock option grants.

Two different alert D & O Diary readers forwarded a link to the Law.com article, including Adam Savett at the Lies, Damned Lies blog and a loyal reader who prefers anonymity. Thanks to both.

Heard Melodies are Sweet, But Those Unheard are Sweeter; Therefore, Ye Soft Pipes, Play On: In a prior post (here), The D & O Diary took a look at the liability exposures for companies engaging in PIPE (Private Investment in Public Equity) transactions. (The prior post provides background about the nature and structure of these transactions.) Two recent SEC enforcement actions shed additional light on the issues and pitfalls that these transactions can sometimes present.

On December 12, 2006, the SEC announced (here) that it had filed a Complaint against Edwin "Bucky" Lyon, Gryphon Partners, and several Gryphon investment funds, in connection with thirty-five different PIPE transactions during the period from 2001 to 2004. The complaint alleges that after agreeing to invest in a PIPE transaction, the defendants sold the issuer's stock short through "naked" short sales (that is, without owning shares to cover their short position) in Canada. Once the resale registration statement was effective, the defendants used the PIPE shares to cover their short position. The complaint also alleges that the defendants falsely represented to the PIPE issuers that they would not sell or transfer their shares other than in compliance with the securities laws. In addition, the complaint alleges that the defendants relied in inside information when they engaged in the short sales. The defendants are alleged to have realized more than $3.5 million in ill-gotten gains.

On December 20, 2006, the SEC announced (here), the filing of a separate settled complaint against broker-dealer Friedman, Billings, Ramsey & Co., its former Co-Chair and Co-CEO, and its former Director of Compliance. The complaint's allegations relate to a 2001 PIPE transaction in which the Company acted as placement agent. The Company is alleged to have sold the issuer's shares short while aware of material, nonpublic information prior to the public announcement of the PIPE transaction. The Company covered its short position with shares it bought from its own customers who had bought their shares in the PIPE offering. The Company's total trading profits were under $450,000 (although its underwriting fee on the PIPE transaction was $1.764 mm), but it agreed to civil penalties of $3.756 mm, without admitting or denying the charges. The individual defendants, who also did not admit the charges, agree to lesser penalties and constraints on their ability to serve in similar roles. The company's press release about the settlement may be found here. An interesting discussion of the case on the SEC Actions blog can be found here.

While these cases illustrate some of the pitfalls of PIPE transactions, it is significant that they do not involve charges against the issuer companies - as I pointed out in my prior post, most of the enforcement proceedings relating to PIPEs transactions involve the broker dealers or the investors, but not the issuing company. There is nothing about these two new actions that changes my prior statement that issuer companies involved in these transactions should not be treated as suspect merely because the engaged in a PIPE financing. Both of these cases also relate back to the 2001 time frame, which, as my prior post pointed out, was a period when these transactions were less structured and involved greater perils. Nevertheless, it is clear that the SEC is taking a look at these transactions.

The quotation in the caption of this item (about "soft pipes," and which admittedly has nothing to do with the item itself) is of course from "Ode to a Grecian Urn" written in 1820 by John Keats after viewing an exhibit of Greek artifacts accompanying the Elgin Marbles at the British Museum. The Elgin marbles are the remnants of marble sculpures removed from the Parthenon. Their removal to England has been a controversy since Lord Byron wrote his "Childe Harold's Pilgimage" ("Curst be the hour when from their isle they roved").

Holiday Interlude: The D & O Diary will be slowing down over the next few days. Readers can look forward to the resumption of the normal publication schedule after the New Year. Happy Holidays to all.

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A casual reader of the New York Times business page or the Wall Street Journal might well get the impression that PIPEs (private investments in public equity) financing transactions are the devil's own handiwork. Both publications have recently run stories fraught with dire tones and ominous insinuantions about PIPEs transactions. The New York Times August 13, 2006 article (here, registration required) entitled "Secrets in the Pipeline" is a particularly egregious example. The D & O Diary is concerned that this perspective on a type of financing that is becoming increasingly popular could lead to the inaccurate and unwarranted perception that companies involved in PIPEs financings all belong in a particularly suspect risk class. While there are PIPEs transaction characteristics that could well suggest larger problems, there is nothing inherent about a PIPEs financing transaction that should cause a company resorting to this type of financing to be viewed with suspicion.

PIPEs transactions typically are structured as a minority investment in a publicly traded company. PIPEs offer accredited investors the opportunity to acquire company securities at a discount to the securities' market value. The issuer undertakes to register the PIPEs securities with the SEC, usually within 90 to 120 days of the transaction closing. There are two main types of PIPEs, traditional and structured. In a traditional PIPE, the company issues common or preferred stock at a set price. In a structured PIPE, the company issues debt securities that are convertible into common or preferred shares according to a conversion ratio that may vary.

PIPEs are an established part of the financial landscape. In 2005, there were a total of 1,301 PIPEs transactions, worth $20 billion. As of August 2006, there have already been nearly 800 PIPEs transactions worth $18 billion.

A PIPE transaction offers the issuing company certain advantages compared to other capital raising alternatives:

• Flexibility: SEC registration is not required prior to offering or closing;
• Transaction Size: To complete a secondary offering, investment bankers and investors require a minimal transaction size, roughly $ 75 mm or more. A company that needs a lesser amount, or that is simply too small to engage in a transaction of that size, has greater flexibility with a PIPEs transaction;
• Efficient Use of Management's Time: The preparation required for a PIPE is minimal compared to a secondary offering, and there is no need for management to become involved in roadshow meetings, etc.

PIPEs do have downsides for the issuing company. PIPEs are dilutive of existing shareholders' equity interest, but so too are secondary offerings. PIPEs may also attract short term investors whose interests may not align with those of management or other shareholders, as discussed below.

Investors are attracted to PIPEs for a number of reasons:
• Discount Pricing: Issuers offer securities as a modest discount (5% to 25%) to the market value, in light of the initial illiquid nature of the securities before the registration process is complete;
• Public Market Liquidity: Once the registration process is complete, investors can sell into the public market;
• Speed to Closing: Since the company is already public, extensive information is already available and there is no SEC registration process before closing.
There are disadvantages for investors, primarily because a PIPE transaction usually involves only a small stake in the company. Investors do not acquire a sufficiently large stake to be able to control the company's board or the timing or outcome of major corporate decisions.

History may explain part of the reason PIPEs are often viewed with suspicion. PIPEs transactions have been known as "death spiral" or "toxic" offerings, primarily as a result of PIPEs transactions completed during 2000 and 2001, when the declining stock markets made it difficult or impossible for many companies to raise money through secondary offerings. During that period, companies conducting PIPEs by issuing convertible preferred securities where the conversion ratio changed based on the company's share price. Companies found that investors had every incentive to drive down the company's share price after closing so that investors could get more company shares upon conversion. Many of these transactions ended badly for the companies involved, and indeed for investors as well. The wreckage from that era has been cleared, and structured PIPEs now represent a much smaller portion of the market, and usually incorporate mechanisms (caps, floors, etc.) to remove or minimize incentives for investors to push shares down.

Another reason PIPEs may be viewed with suspicion these days is that the PIPEs investors increasingly are hedge funds. Hedge funds buying securities in a PIPE are not acquiring a controlling ownership position, so their opportunity to gain from the transaction is not dependent on a restructuring or a management change; the investors must make profits from the transaction itself. So many hedge funds will "hedge" their position by selling the company's stock short, to ensure gains even if the company's shares decline. This understandably may make many managers and existing shareholders uneasy because of the hedge funds' mixed motivations. Companies can set contractual limits around the timing or amount of investors' short selling, but that typically will come at the price of a larger discount on the securities offered in the PIPE transaction.

The complicated and potentially conflicted role of the PIPE investor is clearly of concern to the SEC, and in recent months there have been several SEC enforcement proceedings focused on PIPEs investors' activities:

• In March 2006, the SEC settled with three hedge funds and their portfolio manager for alledgely engaging in "naked" short sales, whereby the shorted shares in PIPEs transactions without actually borrowing publicly traded shares to cover their short position. (Short sellers cannot cover their short position with securities acquired in the PIPE transaction because they are not publicly available shares during the pre-registration period.) One of the hedge funds also shorted the company's shares before it was publicly known that the company sought to raise money in a PIPE transaction. A copy of the SEC's press release on this action can be found here.
• In May 2006, the SEC settled an enforcement action against a hedge fund advisor and its portfolio manager for trading in the shares of 19 companies based on information that the companies were about to announce PIPEs transactions. A copy of the SEC's press release on this action can be found here.

These and other SEC enforcement actions (which can be found here and here) generally are focused on investors' conduct or the conduct of the broker handling the PIPE transaction, rather than the conduct of the issuing company. At least recently, the problems have not involved the issuing companies.

To be sure, there are transaction attributes that can justify wariness of companies engaged in PIPEs transactions:

• Reset or variable rate PIPEs: These types of transactions are still getting done, but they are clearly riskier deals. The riskiest of all are transactions that lack or have insufficient caps or floors on the conversion ratio for convertible securities, because these transactions hold the "death spiral" potential. It is unlikely that any company that has other financial options would enter a transaction of this type.
• Officers or directors buying shares in a PIPE transaction: This is obviously a problem - shares are being offered at below market values in a transaction that is not public knowledge until after closing. At a minimum, it raises the possibility of self-dealing or conflicts of interest (for example, in setting the level of the discount), and it raises concerns about shareholder approvals as well.
• Excessive discount: Discounts for PIPEs securities typically are modest, in the range of 5 to 25%. Discounts at a level greater than this suggest desperation or the existence of some other problem with the transaction.

So the picture with respect to PIPEs can be complex. But companies engage in these transactions for important and legitimate reasons, and therefore PIPEs are likely to remain an important part of the financial landscape. Clearly, the many companies engaged in these transactions cannot be treated as suspect simply because they have resorted to PIPEs financing. A company that has completed a PIPE should not be treated as a suspect D & O risk simply because of the PIPE. As noted above, there are features that could make a PIPE transaction riskier, but in the absence of those characteristics, a PIPE transaction alone should not make the company a suspect D & O risk.

A particularly good short summary on about PIPE financing can be found here. A more academic (and slighly dated) overview can be found here.

A good brief examination of a single company's motivations and experience with PIPE financing can be found here.

Professor Larry Ribstein also has a post (here) on his Ideoblog that is critical of the New York Times' article about PIPE mentioned above.

Options Backdating Litigation Update: The D & O Diary's list of options backdating lawsuits (here) has been updated to add the new securities fraud lawsuit that has been filed against Apple Computer (here) and certain of its directors and officers alleging misrepresentations and omissions in its SEC filings and proxy statements about the company's alleged stock options practices. The addition of the Apple lawsuit brings to 15 the total number of companies sued in purported class action securities fraud lawsuits alleging options timing manipulations.

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