This week, the authors of SEC Enforcement in the PIPE Market: Actions and Consequences are presenting their paper at the CFA-FAJ-Schulich Conference on Fraud, Ethics and Regulation. Their work discusses the SEC’s early 2000s reforms affecting the PIPE (private investment in public equity) market. The SEC intended these reforms to “reduce the opportunities for investor stock price manipulation.” This article contends (and the paper hints) that the SEC’s efforts to crack down on this price manipulation not only had unintended deleterious effects on the PIPEs market but also had little impact on the intended target of the reforms—investor exploitation of companies seeking PIPE capital.
A PIPE transaction is a unique way for distressed companies to publicly solicit capital and external financing from privately-held investors, such as hedge funds and private equity funds. A PIPE is generally a good way for these companies to get “faster access to the cash they  need.” Plus, a PIPE can be “finely tailored to match the particular needs of a given investment.” PIPEs are the sale of “unregistered securities by a public company to a selective group of individuals or institutions.” These types of transactions are legal under Section 4(2) or Regulation D under the Securities Act. Structurally, “[t]he pricing of a PIPE is measured as the ‘net discount’ between the common equity share price and the PIPE-issued equity price.” This discount results from two unique features of PIPEs transactions. First, since distressed companies use PIPEs as a way to get capital quickly, these transactions come at a premium as compared to traditional routes of financing. The second reason for the discount is that there is a time lag between the transaction and the investor’s ability to resell or short the PIPEs securities purchased. This time lag is due to the need for SEC approval of the deal. Given this “temporary illiquidity,” investors get a substantial discount on these securities.
A big criticism of the PIPE market, however, is that it results in the exploitation of the distressed companies issuing these securities. For example, “PIPE contracts often include too many investor-friendly cash flow and control rights . . . .[S]uch onerous contract design could allow investors, in particular hedge funds, to exploit issuers by pushing the stock price down (by shorting) and then receiving additional shares as contractual compensation for this price decrease.” The SEC targeted its reforms at this potential price manipulation, particularly by hedge funds. “Importantly, the SEC did not launch its actions because the agency wanted to shut down the PIPE market as a whole, but rather because it wanted to reduce the usage of investor-friendly reprising rights and lack of trading restrictions in PIPE transactions.”
With the goal of eliminating price manipulation, and thus returning some rights in these transactions to the issuers, the SEC focused on “removing aggressive repricing rights and regulating trading activities.” Since price manipulation would be hard to claim and litigate in court, the SEC instead focused on “the act of shorting securities obtained in a PIPE offering, which is much easier to prove.” To do this, the SEC filed lawsuits against different hedge funds alleging that these funds either illegally sold an unregistered security or engaged in insider trading. This method of reform resulted in expensive, protracted litigation, a successful deterrence measure for the rest of the hedge funds engaging in the PIPE market. Since the market responded positively, PIPEs done in the post-action period “were less likely to have the aggressive repricing rights . . . and more likely to include contract terms that restrict investors from trading the issuer’s stock. “ So these reforms resulted in what the SEC intended, right?
While at first glance it may seem that the SEC’s targeted reforms and enforcement measures may have done a great, tailored job, a deeper examination finds that not only are there now “more investor protections and less issuer rights” in PIPEs contracts, but there were other unintended side effects of the enforcement that has impaired the PIPEs market.
The first possible issue with the SEC’s tactics is that its reform measure of choice, suits against hedge funds for either insider trading or selling an unregistered security, largely failed to gain any traction in the courtroom. Using these proxies to try to prevent price manipulation was generally found to be too flimsy. In fact, there was really only one case, SEC v. Berlacher, where the court ruled in favor of the SEC. Further, this victory is nuanced from the vast majority of the similar suits filed against hedge funds since “[t]he court found that Berlacher and co-defendants had committed fraud, but only with respect to instances in which they represented themselves as having held no short position in the PIPE issuers’ securities while they did in fact hold such a position.” For most of the suits filed, this type of fraud was not alleged. Overall, this means that the SEC’s failed courtroom campaigns changed the way PIPEs transactions were conducted. Despite its inability to win these cases in court, the SEC still achieved its end goal of standardizing “less aggressive repricing rights and more restrictions on trading.”
While the impotent court campaign seemingly worked to stop the factors causing price manipulation, the results of these enforcement measures do actually beg the question of what the SEC’s true goal was, and whether this goal was actually achieved. Was the SEC trying to just fix the price manipulation problem, or was it trying to aim bigger and give more power and rights to the troubled, issuer companies? Sure, the factors that could lead to price manipulation were basically stamped out by the SEC’s reforms; however, the post-action period did not result in a power dynamic shift towards the issuer companies in these transactions. Hedge funds remained in power through increased investor protections and decreased issuer rights. So if the SEC was aiming big, it definitely failed to shift the power balance. Instead, power and control remains firmly in the hands of the investors, especially the big-player hedge funds. Through contractual arrangements in the post-reform period, the paper found that there were actually more investor protections and rights, and that the pricing of the PIPEs was even more favorable to the investor than before the SEC crackdown.
[A]ll types of PIPE investors responded to the SEC’s actions by substituting away from contractual rights that were under scrutiny towards other contractual rights that were not. Although such substitution may have left the aggregate level of investor-friendliness in PIPE structures unchanged, it was associated with marked modifications to the precise allocation of contractual rights. [I]nvestors could more often mitigate investment risks by exercising various investor-friendly contingent cash flow rights, without giving away similar rights to issuers.
It seems that basically, the parties just used contractual maneuvering to shift where the investors got these protections. The SEC reforms did not give any of the power back to issuers.
Additional unintended consequences resulting from the SEC’s actions were seen in an increase in capital costs and the elimination of small players from this market. Since the reforms, issuers have relied more heavily on placement agents to get the deal done right. These agents cost money. Additionally, the PIPEs capital comes at a greater discount to the investors now than it did in the pre-action period. This means that to raise capital through PIPEs is now more expensive than it was in the pre-reform/enforcement period. In conjunction with the capital cost increases, the smaller players being driven out of the market leaves the big hedge funds as the solitary sources of capital for distressed companies. These big hedge funds have better bargaining power and get the most favorable treatment possible for themselves in these deals, leaving many of the most distressed companies unable to even enter such transactions. This narrowed the scope of which companies can actually seek PIPEs financing—a troubling by-product for a transaction that is meant to serve as a way to get easy capital for troubled companies.
In sum, it seems like the SEC did not fully think through their plan of attack before engaging in its reforms. While price manipulation is definitely less likely to occur, the byproducts of the SEC’s actions have had a much more substantial impact to the PIPE market than the SEC anticipated. The ripple effect has left the PIPE market still dominated by the hedge fund players. It seems that in trying to reform the PIPE market, the SEC failed to fully take stock of the purpose of the PIPE market and, as a result, created a lot of unintended damage.
Related article: Ola Bengtsson, Na Dai & Clifford Chad Henson, SEC Enforcement in the PIPE Market: Actions and Consequences (April 3, 2012). Illinois Program in Law, Behavior, and Social Science Paper. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2033950