David Feldman's book, Reverse Mergers: Taking a Company
Public Without an IPO, now in its third printing, was published in 2006
by Bloomberg Press (available on http://www.amazon.com).
View David Feldman's reverse merger blog at www.reversemergerblog.com.
Joseph Smith and David Feldman are coauthors of PIPES:
Revised and Updated Edition - A Guide to Private Investments in Public Equity
(Bloomberg Press, 2005) available on http://www.amazon.com.
In the News
Joseph
Smith quoted in an article regarding
short shares. The Pipes Report, June
15, 2005.
Silence
on PIPE Hedging Strategy Stirs Concern:
SEC May Halt Reserving Short Shares
by
Joe Gose
It
appears that the Securities and Exchange
Commission is taking notice of a private
placement, hedging strategy commonly
referred to as "pay-to-hold" or "pre-borrowing,"
in which investors reserve shares once
a deal is announced. Earlier this
spring, not only did the SEC refuse
to provide a no-action letter on whether
the practice complied with securities
laws on behalf of a client represented
by a securities attorney Joseph Smith,
but commission staffers also were tight-lipped
about what their refusal meant.
"They shrugged it off and said absolutely
no comment," says Smith, a partner with
Feldman Weinstein. "I have a feeling
they're looking at it in a head-scratching
kind of mode rather than in a what-are-these-bastards-doing-now
mode." A spokesman with the SEC
declined to comment on whether the commission
was investigating the practice, and
an SEC agent enforcing short-selling
regulations declined an interview request.
But there's little doubt about the SEC's
interest in judging practices within
the PIPE arena, as evidenced by the
SEC's, NSAD's, and Department of Justice's
investigations--two years old and running--into
short selling fraud against PIPE issuers.
On May 16, the commission settled a
complaint with former hedge fund manager
Hillary L. Shane, who short sold a PIPE
issuer before the deal closed. Three
days later the SEC announced it had
reached settlements with DB Investment
Managers, Oaktree Capital Management,
and Galleon Management for engaging
in short selling and covering transactions
prohibited by Rule 105 of Regulation
M.
The SEC also has issued broker Refeo
Securities a Wells notice in relation
to the short selling of Sedona Corp.
A Wells notice means the SEC has found
possible rule violations and gives the
company time to respond before filing
a civil complaint.
The curiosity about short selling has
become evident even in informal meetings
with the SEC. Earlier this month, four
attorneys with Lowenstein Sandler made
a presentation on private placements
to 25 SEC staff lawyers in the commission's
corporate finance, enforcement, and
market regulation divisions. Jack Hogoboom,
a partner with Lowenstein Sandler who
was part of the delegation, said the
group hoped to elicit a dialogue with
the SEC about the importance of PIPE
market and how some SEC rules had affected
it. But instead of hearing SEC options
about PIPEs, the handful of attorneys
fielded a lot of questions. And many
of the queries targeted short selling
strategies. "They made a specific issue
about how people were hedging," Hogoboom
says. "They think that s the next hot
button."
Preparing a Hedge
A number of PIPE funds are known to
use the pay-to-hold strategy in discounted
common stock deals. To reserve shares
for a future short sale, the funds tap
the pre-borrow services offered by prime
brokers such as Goldman Sachs, Solomon
Smith Barney, Bear Stearns, and Banc
of America. Prime brokerage representatives
at two firms declined to comment about
the service but investors typically
pay for the right to pre-borrow the
shares for the time the stock is reserved,
according to PIPE insiders.
Often the market's reaction to a PIPE
announcement drives down a company's
stock price to the level of the PIPE
discount or lower, but the pay-to-hold
strategy gives PIPE investors a chance
to hedge their bets by capturing an
issuer's prevailing stock price as the
market first learns about the deal.
At least one investor, however, suggests
pre-borrowing creates an unfair playing
field for other investors who lack the
information about the potential PIPE,
or the cachet with prime brokers to
reserve a large number of shares for
a short sale. Those investors, including
hedge funds taking part in a private
offering of a hard-to-borrow stock,
often see their investments decline
immediately.
"Obviously the SEC is saying that shorting
before the deal closes is insider trading,"
said one PIPE investor, who spoke on
condition of anonymity, referring to
the Shane case. "But the SEC may be
taking it one step further: If you're
tying up the borrowable shares to short
sell when the deal's announced, you
may not only be prejudicing other participants
in the deal, but also shareholders in
the company. Why? Because if Joe Blow
from Iowa doesn't know anything abut
the deal but wants to short the stock,
he can't. Why not? Because somebody
already has tied up the borrow. Why
did they tie it up? Based on the information
of a deal."
Changing the Covers
One element that has changed within
the pay-to-hold and other hedging strategies
centers on how PIPE funds cover their
short sales. In the past, investors
often would cover short sales with shares
issued under the effective registration
statement, but the SEC's scrutiny of
short selling in conjunction with private
placements began creating uncertainty
about the strategy. In late May, Daniel
Hawke, an SEC associate district administrator
for enforcement in Philadelphia who
was involved in the Shane case, made
the most definitive statement to date:
PIPE investors cannot execute short
sales and cover the sales with shares
from PIPE offering.
Thus, PIPE investors typically cover
their free-trading shares before the
registration statement is effective.
Fund managers also may sell shares issued
under the PIPE into the market, which
converts them to free-trading shares,
and then buy them back immediately to
cover short sales.
The method PIPE investors use to cover
their short sales that arise from a
pay-to-hold arrangement may become a
moot point if the SEC decides to weigh
in on the strategy. For his part
Smith suggests that the SEC doesn't
have jurisdiction over the practice.
"You're still not buying or selling
a security, nor are you locking up a
security at a particular price," he
says. "All you're doing is precluding
someone else, who may or may not exist,
from borrowing a specific number of
shares. And I don't think that's a transaction
in a security."
The SEC may have other ideas, of course,
and ultimately could bring enforcement
actions against pre-borrowing PIPE investors.
Smith's advice to his fund clients:
Continue to pre-borrow -- depending
upon the fund's appetite for a possible
tussle with the SEC.
