A nice explanation of PIPES
A Troubling Finance Tool for Companies in Trouble
By FLOYD NORRIS
Published: March 15, 2006
When a company goes the route of PIPE's, you can bet that it is in trouble, unable to raise funds through conventional routes. But such companies can often raise millions of dollars, thereby postponing disaster.
PIPE stands for private investment in public equity, and providing such financing can be very profitable, even if the companies later go bankrupt.
Yesterday, in penalizing a New York hedge fund and its lead trader a total of $15.8 million, the Securities and Exchange Commission laid out one — illegal — way that investors get rich on such deals.
Jeffrey Friestad, an S.E.C. lawyer, said the penalty was the largest ever imposed in a PIPE case. "It represents our ongoing commitment to stamp out fraud and ongoing abuses in the PIPE market," he said.
While details vary, PIPE deals usually allow the buyer to buy shares — or securities convertible into shares — at a price below the market price of the stock. The catch is that the shares are not registered with the S.E.C. Buyers are required to sign statements promising not to sell the securities until the registration statement is effective.
The market price usually sags after a PIPE deal is announced, and any investor who buys such an investment and waits for the shares to be registered, usually within a matter of days, risks discovering that the market price of the stock will have fallen below the purchase price.
To avoid that, it is good to short the shares as soon as possible. But to do that in the United States, a trader is supposed to first borrow the shares. And, the S.E.C. says, it is illegal to use the shares obtained from the PIPE to repay the shares borrowed, since that would amount to having sold the PIPE shares too early.
The investor is supposed to buy other shares to cover the short position, and then sell the PIPE shares separately. If the shares are illiquid, there is a risk that prices will move, leaving the trader with a loss.
In addition, the S.E.C. says, it is illegal insider trading to sell the shares short if the seller knows a PIPE deal is coming, but that fact has not been announced to the public.
The complaint against Jeffrey Thorp and three hedge funds he ran — Langley Partners, North Olmstead Partners and Quantico Partners — says that in 22 deals, PIPE shares were improperly used to cover short positions, often with elaborate ruses aimed at making the tactic hard to discover. In six of those cases, and one other, Mr. Thorp was accused of illegal insider trading by shorting the stocks before the PIPE deal was disclosed to the public.
Mr. Thorp, 42, of New York and the funds settled the case without admitting or denying the S.E.C. allegations. Mr. Thorp also agreed to talk to the S.E.C. when asked.
No phone number could be found for Mr. Thorp or his funds. His lawyer, Andrew G. Gordon of Paul, Weiss, Rifkind, Wharton & Garrison did not return a telephone call.
The S.E.C. allegations indicated that unnamed brokers in the United States and Canada worked with Mr. Thorp to cover up what he was doing.
Asked if the brokers would face charges, Mr. Friestad of the S.E.C. said the commission would "look to see whether brokers had any responsibility for this and bring charges if appropriate."
The S.E.C. said that in the PIPE trades from 2000 to 2002, the defendants realized profits of $7 million. Their tactics included selling shares short without borrowing them, a practice known as naked shorting. But that shorting was done in Canada, where the practice is legal, and no charges were brought over that.
Instead, the charges dealt with fake or prearranged trades intended to make it look as if the funds had bought other shares to cover their short positions.
The S.E.C., in its complaint, described the PIPE market gently, saying companies issue such securities "when more traditional means of financing, such as a registered repeat offering, are for various reasons impractical."
One thing that limits the size of the offerings is that buyers are reluctant to place large orders, out of fear that they will not be able to legally short the shares in time. But the S.E.C. said the tactics Mr. Thorp used led him to seek very large allocations.
Few buyers of PIPE securities invest because they believe in the long-term prospects of the company, so the burden ends up falling on those who buy common stock.
They rarely do well. Of the 23 PIPE deals covered in the S.E.C. complaint, it appears that in 21 cases the common stock is now trading, if it is trading at all, at a price below that paid by the PIPE buyers. Since that price was below the public price at the time, the common shareholders did even worse.
There was one major exception, a company known as HealthExtra. It prospects grew worse, and its sale price fell, in the months after the PIPE deal was sold in 2001. But its business later improved and the share price has risen sharply.
But the rarity of such good outcomes explains why it is usually a good strategy to sell any investment in a company that issues a PIPE as soon as the deal is announced.
AI
