In doing so, they accepted the SEC's theory that a fund manager that agrees to keep in confidence material nonpublic information it obtains when being solicited to invest in a PIPE and then shorts the PIPE issuer's stock can be sued under the antifraud provisions of the federal securities laws.
But what if, as the people from Tennessee argue, the fund manager is shorting simply to hedge? That would be a prudent strategy.
The SEC says invoking Section 5 has been its policy for 35 years? Really? I remember when people shorted against restricted shares routinely. And as the article you cite states, they've really only been going after these sales for the past five or six years, obviously in connection with all the hoopla about naked shorting. I think the Tennessee guys got it right:
The SEC's Section 5 position is wrong because Section 5 is not violated; the conduct in question does not involve a sale or transfer of unregistered securities. PIPE transactions are structured to make the sale or transfer of an unregistered security impossible. When a PIPE investor opens a short position, it borrows and sells a registered security. If the PIPE shares are successfully registered, PIPE investors then typically close out the short position with (their own) registered shares. If the hares are never registered, the PIPE investor would be forced to close out the short position with shares purchased on the open market, which are registered. Consequently, it is impossible for the PIPE investor to sell an unregistered security even if the PIPE shares are not successfully registered.
It goes on to say:
The Court rejected outright the SEC's integration analysis. Instead it concluded that the short sales were transactions distinct from the transactions that later "covered" the short sales with the PIPE shares. In the Court's view, Gryphon's delivery of once-restricted PIPE shares to close the short positions could not be deemed to convert the short sale into a sale of PIPE shares. It said: "[F]rom the Court's perspective, a short sale of a security constitutes a sale of that security. How an investor subsequently chooses to satisfy the corresponding deficit in his trading account does not alter the nature of that sale." As Lyon pointed out, the defendants were under no legal obligation to use their PIPE shares to cover their short positions and could have covered with various kinds of shares - publicly traded shares, shares derived from convertible bonds, or once-restricted PIPE shares.
That makes sense. There were also insider trading allegations made. And they were sustained.
There's also an interesting discussion of the Mark Cuban case that explores the issues involved in insider trading related to PIPEs. In that case, the lower court came to what may seem a rather surprising conclusion about the definition of illegal insider trading. The SEC's argument was based in part on the fact that Cuban had received a call from the CEO of Mamma.com one morning; the first thing the CEO asked was if he'd keep the what he was about to say confidential. Cuban replied that he would. The CEO then said a PIPE deal would be announced in a couple of days. He was basically telling Cuban, the company's largest shareholder, that he was about to lose a ton of money. Cuban was furious, and sold. But he didn't tell anyone about the impending PIPE announcement.
A person who receives material, nonpublic information may in fact preserve the confidentiality of that information while simultaneously using it for his own gain. Indeed, the nature of insider trading is such that one who trades on material, nonpublic information refrains from disclosing that to the other party to the securities transaction. To do so would compromise his advantageous position.
It's a good article, though it makes clear that the issue is far from settled yet.
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