Hedge Fund Short-Sale Tactic Faces Uncertain Future
By Matthew Goldstein
Senior Writer
9/16/2004 10:25 AM EDT
A favorite short-selling strategy of hedge funds trying to score
quick gains when troubled companies cut last-ditch financing deals
with them could be in regulatory danger.
The trade in question involves so-called private investment in
public equity transactions, deals known by the Wall Street acronym
PIPEs, which have recently been the subject of an investigation by
the Securities and Exchange Commission. Last spring, TheStreet.com
reported that nearly 20 brokerages were questioned about PIPE
investments by SEC agents concerned about their potential for abuse.
Within the past few weeks, people familiar with the inquiry say, a
handful of hedge funds also have received subpoenas. While the PIPE
market isn't well known, it is huge. About $14 billion will be
raised in it this year by small companies, many of them cash-poor
biotechs.
Among the issues being probed by regulators is the standard hedge
fund practice of shorting the common stock of a company in which it
is making a private investment, betting on the dilution to existing
shareholders that occurs when a company sells extra stock at a
discount. That dilution, as well as the potential for outright price
manipulation, is why PIPE transactions are generally regarded a
shady area of corporate finance, often hurting less-savvy investors.
A new SEC regulation -- one that affects a close cousin of PIPE
transactions called shelf offerings -- suggests the agency wants to
prohibit the shorting strategy, especially when it happens before a
company publicly announces a deal. While not strictly addressing
PIPEs, the new rule is causing some securities lawyers to advise
institutional investors to rethink the way they do business.
"In most cases, you cannot short in advance of a [PIPE] deal," says
Eleazer Klein, a partner with Schulte Roth & Zabel and a frequent
legal adviser on PIPE transactions. "Barring specific facts, my view
is you should not be doing it."
The new rule, known as Regulation SHO, addresses several problems
associated with short selling. The part that could affect the PIPEs
market concerns shelf offerings, in which companies use a single
registration statement to sell stock periodically and at varying
prices. The practice closely resembles a PIPE deal because of the
informality of its timing. Many of the hedge funds that are active
players in the PIPE market also are investors in shelf deals.
Regulation SHO makes it much harder for an investor in a shelf
offering to short a company's stock five days prior to the pricing.
To many, the new regulation is a sign the SEC also has problems with
the activities of hedge funds that invest in PIPEs, especially when
it comes to short-covering. SEC officials were not available for
comment.
The SEC investigation is focusing on allegations that some hedge
funds improperly used advance knowledge that a company was planning
a PIPE deal to short the company's stock. Such knowledge enables a
near sure-thing short bet -- even if the trader never actually
invests in the PIPE itself.
The new regulation specifically prohibits investors in a shelf
offering from using shares obtained in the offering to cover, or
close out, a short position that was set up in the days before the
offering. This prohibition is significant because an investor who
can cover a pre-existing short position without buying shares in the
public market gets a leg up over other traders.
In an ordinary short sale, a bearish investor borrows stock from a
broker, sells it, and hopes to replace it later with shares
purchased in the market at a lower price. Because shares in PIPEs
deals are usually sold slightly below the market price, hedge funds
participating in them have an even greater incentive to go short,
since the discounted shares they receive make it less costly to
close out the position.
"A trader who sells short pre-pricing and knows he will be able to
cover his shares in the offering, doesn't assume the same market
risk as short sellers who must buy open market shares,'' says Derek
Meisner, an attorney with Kirkpatrick & Lockhart and a former SEC
branch manager.
If the securities lawyers are correctly interpreting the SEC's
intentions, this inherent advantage PIPE investors have over other
traders may be closing. Klein says the toughened regulatory
environment ultimately could help the PIPEs market by driving out
bad actors and elevating the reputation of the market.
Of course, not everyone is convinced that the days of shorting into
a PIPE deal are coming to an end. That's one reason an increasing
number of PIPEs contain implicit written provisions barring
investors from shorting its shares prior to the offering.
But the danger for hedge funds and other PIPE investors is that the
regulatory landscape is in flux, and what is legal one day may later
give rise to a securities fraud violation.
"The [hedge fund] manager is at risk that rules may be interpreted
in a manner not previously interpreted and result in potential
liability,'' says Ron Geffner, an attorney with Sadis & Goldberg in
New York, which has a big hedge fund practice.
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