Court Deals Blow To SEC’s PIPES Enforcement Effort

Nov 5 2007 | 11:22am ET

By Nicolas Morgan and Perrie Weiner

Judge Graham C. Mullen of the United States district court for the Western District of North Carolina dealt the Securities and Exchange Commission a serious set-back in its efforts to impose trading restrictions on hedging activity in the market for private placements in public equities. And with any luck, Judge Mullen’s ruling, issued Oct. 24, may be the beginning of the end for the SEC’s attempted application of Section 5 of the Securities Act of 1933 to PIPEs.

According to the SEC’s complaint, in the fall of 2001, John Mangan—then of Friedman Billings Ramsey, and later to found hedge fund Mangan and McColl Partners, which has since closed its doors—allegedly purchased for a client 80,000 shares of Nasdaq-listed company CompuDyne Corp. in a PIPE. Like many participants in the PIPEs market in 2001, Mangan hedged the PIPE investment by selling short an equal number of CompuDyne shares.

CompuDyne later filed a registration statement for the resale of its PIPE shares and, after that registration statement became effective, Mangan purportedly used the PIPE shares to cover the short position. The SEC also alleged that Mangan’s short sales amounted to insider trading. However, in an approach departing from that of some other cases in the area, the SEC did not allege that Mangan engaged in “matched orders,” “wash sales” or “naked shorting” through Canadian brokers, which the SEC claims are indicators of a deceptive intent.

Nor did this case present the added complications of 10b or 10b-5 charges, bootstrapped to an otherwise “pure” Section 5 claim, where there are alleged misrepresentations in the deal documents such as breached investment intent or a lack of a shorting provision.

What Mangan did not know (and arguably could not have known) in 2001 is that five years later the SEC would allege that, by covering his pre-effective short positions with PIPE shares, Mangan violated Section 5, which essentially requires that every offer or sale of securities must either be registered or exempt from registration.

Beginning in 2005, the SEC began bringing enforcement actions against PIPE traders like Mangan, alleging that short sales prior to the effective date of a registration statement were “effectively” or “deemed to be” unregistered and nonexempt sales of securities if the short positions were later covered by PIPE shares after the registration statement became effective.

Before Mangan

Although academics and practitioners in the area questioned the viability of the SEC’s novel Section 5 theory, for years no court had an opportunity to scrutinize the theory: Like most other SEC enforcement actions, every such Section 5 defendant settled before the case went before a judge. In most cases, the SEC used the threat of a bar from the investment-adviser or broker-dealer industries to exact agreements from these defendants. As a result, the cost and risk involved in challenging the SEC’s Section 5 theory in court often outweighed the monetary penalties levied in the settlements.

However, Mangan decided to fight back. The SEC brought its action against his on Dec. 28, 2006, and he promptly filed a motion to dismiss the complaint, arguing, among other things, that nothing about Section 5 prohibited the conduct he was alleged to have engaged in, and the SEC was, in effect, trying improperly to impose new regulations through litigation that would greatly expand existing law.

Dismissed In Its Entirety

On Oct. 24, Judge Mullen, the first judge to weigh in on this issue, agreed with Mangan and dismissed the SEC’s Section 5 claim in its entirety. Ruling from the bench in Charlotte, N.C., Judge Mullen said:

The government’s allegation of a Section 5 violation is certainly creative. And while there seems little doubt that the defendant sold short anticipating the receipt of PIPE shares to cover the short, it’s also true that in any case he would have had to cover with the shares purchased in the open market should the PIPE fail to close or been withdrawn or otherwise not be available to produce those shares. Anybody who bought at the sale of the securities got CompuDyne. They got what they bought.

And what we have here, it seems to me, is a post hoc ergo propter hoc argument by the government that because the PIPE in fact was not registered and because the PIPE shares were later in fact used, he in effect sold the PIPE. Well, maybe, but I don’t think he did anything illegal. In short, no sale of unregistered securities occurred as a matter of law. And since that is this court’s ruling, there is no need to parse the various Olympian rumblings from the SEC and compare them to the Commission’s startling publications in the Federal Register or otherwise to come up with some notion about how he had notice after all because I’m holding as a matter of law there was no alleged Section 5 violation and the motion to dismiss as to that is granted.

As to the SEC’s insider trading claim, the court denied Mangan’s motion to dismiss, noting that the decision was “a close case—dare I say, very close case—particularly in view of the apparent nonevent that the announcement of the PIPE seemed to be.” Although the court’s analysis of the insider trading issue appeared to focus on the particular facts and circumstances of this case, including the timing of Mangan’s short sale order versus the execution of that order, the judge’s conclusion that the announcement of the PIPE was a “nonevent” does not suggest confidence in the SEC’s position.

Will SEC Appeal? Will It Eventually Reevaluate?

It remains to be seen what impact, if any, this ruling will have on the SEC’s enforcement activity in the PIPEs area. At the heart of Judge Mullen’s ruling is the recognition that buyers on the opposite side of short sales receive issuer stock regardless of what method is later used to cover that short position.

Despite that keen judicial observation, the SEC may appeal the ruling, and, certainly, the agency continues to assert its Section 5 theory in other active cases in other jurisdictions. Indeed, the next court to weigh in on this issue likely will be the United States District Court for the Southern District of New York, where the SEC has sued Gryphon Partners using the same Section 5 theory asserted in Mangan’s case but with more egregious allegations of “wash sales,” “matched orders” and “naked shorting” through Canadian brokers.

Like Mangan, Gryphon has moved to dismiss the SEC’s claims. Since earlier this year Gryphon’s motion has been fully briefed by both sides and awaits the court’s decision. If the New York court also decides that the SEC’s Section 5 theory has no merit, we might expect and hope that the SEC will reevaluate its enforcement program in this area.

Nicolas Morgan and Perrie Weiner are partners at international law firm DLA Piper.

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