SEC Looking Closer at 'Statutory Underwritings'
For The Pipes Report
The U.S. Securities and Exchange Commission (SEC), along with state regulators and the National Association of Securities Dealers (NASD), are taking a closer look at whether investors in PIPEs are violating rules governing the redistribution of securities to the retail public – a form of “statutory underwriting,” according to investors and others involved in private investments in public equities.
While there have been no recent cases where a PIPE was actually prevented from going through, or a post-transaction litigation, the increased oversight has slowed up some transactions and is prompting attorneys to take extra care in making sure that pre-issue documentation satisfies SEC requirements.
“Affiliates of broker dealers may participate in PIPEs if they acquire the PIPE securities in the ordinary course of their business, for their own account, and for investment purposes,” says Eric Cohen, an attorney at Bryan Cave in New York who has worked on numerous PIPE transactions. “They should represent that they have no agreement or understanding with any person, directly or indirectly, to resell or distribute any of the PIPE securities.”
The increased scrutiny no doubt comes from the higher number of investment banks whose fund units have been making investments in PIPE transactions in recent years. Merrill Lynch, Goldman Sachs, Lehman Bros., SG Cowen and CIBC Capital Markets are just a few of those that have delved into the red-hot market for making private investments in publicly traded companies. Also, some PIPE investment bankers have recently launched their own merchant banking and fund management subsidiaries and could also be subject to the higher scrutiny.
The SEC has explicitly stated that broker dealers are not eligible to invest in PIPEs and then resell the PIPE securities on a secondary basis, as broker dealers are inherently underwriters and lack investment intent. The intent of the SEC is to make sure that companies do not violate Section 5 of the Securities Act, which states that a company is not permitted to sell securities, absent an exemption, unless a registration statement has been filed with the SEC. PIPEs transactions are a form of allowable exemption, and the SEC wants to make sure that companies and investors don’t abuse that exemption by reselling unregistered shares to the general public. In essence, doing so would be a way of subverting the SEC’s requirements regarding disclosure, the distribution of prospectuses, and everything else that comes with the registration of securities.
PIPEs are allowed in part because they are private transactions that are negotiated between the company and a group of accredited investors for their own account. During that process, the investors involved are often provided with information that is not available to the retail public, and those investments are made based on a level of sophistication and disclosure that not only meets but in most cases exceeds the level of disclosure to retail investors. Those negotiated shares, however, must be seen as “coming to rest” with the funds rather than being held as inventory for redistribution to the investment bank’s retail investors.
For investment banks, “The point is to make sure you are not acting as a conduit for the shares, in essence acting as an underwriter,” says Ele Klein, an attorney at Schulte Roth Zabel in New York. “That doesn’t necessarily mean you can’t do a private placement on behalf of other accredited investors, as long as that is disclosed.”
Klein says it’s important for both issuers and investors to make sure they make the proper disclosures ahead of time, because the penalties for violating Section 5 could be severe if it’s discovered after the fact. Enforcement action could be brought not only against the investor who redistributed the shares but also against the issuer “if they were in a position to know better,” Klein said.
Says Cohen: “This issue is not new and extends the logic of the Exxon-Capital line of no-action letters issued by the staff of the SEC several years ago. While it is true that the SEC is looking at this issue in its review of PIPE registration statements, we do not feel that the issue is indicative of any abusive practice. Rather, this is simply another rule to be followed to make certain that the PIPE is structured properly so the subsequent registration statement qualifies as a valid secondary offering.”
Originally, Exxon Capital exchange offers were a way of enabling issuers to obtain the certainty and speed of a private placement in raising capital while avoiding the price discount that typically accompanies a restricted private offering.
Within the last several years, courts and the SEC started applying the same line of reasoning to PIPEs transactions. PIPEs are typically sold at a discount to the publicly traded share price at the time. While such issues dilute shareholder value, they are often valuable to the company issuing the shares because they are fast and efficient ways of raising capital that may be needed for a growth opportunity or as a cash infusion for a distressed company. And in the long run, it may inflate the original value of the shares, benefiting common shareholders as well.
If a PIPE investor were buying shares with the intent of immediately redistributing them to the general public, they would therefore have an unfair advantage because they could buy them at a discount and sell them at market price to retail investors. What’s more, it could also violate contractual lock-up periods for PIPEs, which can range from 30 days to as long as a year, during which time securities sold via PIPEs are supposed to be completely illiquid and investors are not allowed to exit.
But while unfair price discounts are an obvious concern, investors involved with recent issues said the SEC seems more concerned about unregistered shares being sold to unaccredited investors without the proper disclosures and investor protections that common stock registration entails.
“It’s more an issue of disclosure and protection of the marketplace,” says Klein.
The rules governing redistribution do not apply to shares that are given to placement agents or others involved in the transactions as compensation for completing the deals. Nor do they apply to convertible debentures that are issued along with PIPE transactions – which have their own series of limitations and restrictions.
While the increased scrutiny may slow some PIPE issues coming to market, the end result may be a positive for the industry because, like other such rules, it will weed out the potential of investors getting involved in PIPEs for the wrong reasons. Like the NASDAQ’s 20 percent rule – which states that shareholder approval is required for PIPEs sold on NASDAQ-listed securities at below market price if the amount of shares being sold is greater than 20 percent of the company’s outstanding common stock – it will take some getting used to but could help remove some of the negative stigma to PIPE transactions that have discouraged some issuers and raised the ire of common shareholders. Indeed, it’s another step toward bringing U.S. rules governing PIPEs closer to the European rules which have much stricter safeguards for common shareholders.
And like the SEC’s stepped-up actions governing post-PIPE short selling, as well as Section 16 – which prohibits “short swing” trading profits – the “statutory underwriting” enforcement will undoubtedly prompt investors with ulterior motives to drop out of the market, and could prompt some PIPE investment banks and placement agents to rethink expansion plans and be more careful about who they invite in as investors.
For retail investors, the SEC’s scrutiny could help prevent potential abuses that could allow wealthier investors and institutions with inside knowledge to gain an unfair price advantage on publicly traded securities. It could also help guarantee that retail investors be equipped with the proper amount of disclosure.