Hedge Fund Short-Sale Tactic Faces Uncertain Future

By Matthew Goldstein

September 16, 2004

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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