Confidentiality, Standstill and Insider Trading Considerations Relevant to Hedge Funds Investing in PIPEs

In November 2007, Scott Friestad, Associate Director of the SEC’s Enforcement Division, announced that trading abuses would be a priority for the then-newly-launched Hedge Fund Working Group.  He defined “trading abuse” to include abuses of private investments in public equity (PIPE) transactions, as well as insider trading and improper short sales under Regulation M.  But the advertised crackdown was already underway.  For example, that September, the SEC had initiated an enforcement action against Robert A. Berlacher and others alleging that the defendants had engaged in unlawful insider trading in connection with the Radyne ComStream Inc. PIPE offering of 2004, by selling short Radyne securities prior to the public announcement of the PIPE.  As an alternative theory of liability, the SEC also alleged that the trading violated Section 5 of the Securities Act of 1933 (Securities Act).  Section 5 generally requires that every offer or sale of securities must be either registered or exempt from registration.  The SEC claimed in Berlacher and analogous cases that the use of PIPE shares after the effective date of the relevant registration statement to cover short sales made prior to the effective date of the relevant registration statement effectively constituted an unregistered sale of securities that required registration.  The SEC has since suffered a series of setbacks in connection with PIPEs, especially with respect to its Section 5 theory of liability.  The various dismissals of claims under Section 5 are, in turn, part of a broader pattern of setbacks for the SEC in its enforcement efforts in connection with PIPEs, and the decisions that have resulted from this effort have affected the practices of issuers, placement agents and investors.  This article reviews the mechanics of PIPE transactions and the informal confidentiality arrangements traditionally entered into by PIPE issuers and investors.  The article then surveys the insider trading caselaw applicable to investors in PIPEs (many of whom are hedge funds); the insider trading claims against Mark Cuban, which were dismissed in July of this year, including insights from the lawyer who successfully represented Cuban in that matter; the changing dynamics of the PIPE marketplace, including the entry of more sophisticated issuers, and the concomitant new emphasis on the terms of confidentiality and standstill agreements; and the materiality of PIPEs in any insider trading analysis.

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