ALI-ABA Course of Study Postgraduate Course in Federal Securities Law. June 28-29, 2007 Boston, Massachusetts. PIPES Hedging Under Scrutiny

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1 797 ALI-ABA Course of Study Postgraduate Course in Federal Securities Law June 28-29, 2007 Boston, Massachusetts PIPES Hedging Under Scrutiny By Alan J. Berkeley Jennifer Hieb Woojung Kim Kirkpatrick & Lockhart Preston Gates Ellis LLP Washington, D.C.

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3 799 PIPES HEDGING UNDER SCRUTINY Alan J. Berkeley Jennifer Hieb Woojung Kim Kirkpatrick & Lockhart Preston Gates Ellis LLP June 2007 Financing through PIPEs became extraordinarily popular in the late 1990s, hitting a peak in 2006 (1,320 transactions, amounting to almost $28 billion) mainly because PIPEs can be advantageous to both issuer companies and investors. PIPEs can offer a company the speed and predictability of a private placement, while providing investors with securities at a discount to the market price and the possibility of prompt liquidity. In early 2004, the SEC and the NASD began to investigate certain hedging strategies employed by some PIPEs investors or their investment advisors. To date, these oftentimes parallel inquiries have spawned myriad lawsuits and regulatory actions, and threats of more, involving novel and complicated legal issues related to hedging strategies. 1. What Is a PIPE? PIPE stands for private investment in public equity. In a PIPE transaction, an underwriter or placement agent privately places restricted securities of a public company with investors meeting certain criteria ( accredited investors ). Accredited investors enter into a purchase agreement with the issuer committing the investors to purchase a certain number of shares at a specified price. The issuer, in turn, agrees to file a resale registration statement with the SEC within a specified period so that investors can resell the shares to the public. PIPEs need not be equity investments. PIPEs can be common stock, debt, convertible securities, equity lines of credit or other hybrids. Private placements of common stocks or fixed convertibles at predetermined prices or conversion ratios are called traditional PIPEs. Private placements of variable convertibles at conversion ratios that depend on the performance of the underlying stock after the PIPE issuance are called structured PIPEs. 2. What Are the Benefits to Using PIPEs? PIPEs provide significant benefits for issuers because PIPEs are faster, less cumbersome and often less expensive than public offerings. Because PIPEs are sold to a limited number of qualified investors, issuing a PIPE can reduce the offering costs and time associated with information DC v11

4 800 production and SEC registration. Moreover, PIPEs usually involve less market risk once the process has begun. Historically, these advantages have led less seasoned and more volatile companies in capital-intensive industries, such as biotechnology, pharmaceuticals, Internet, oil, gas and other natural resources, to employ PIPEs as a financing option. Offerings often are accompanied by variable priced sweeteners, such as warrants, that permit investors to buy additional shares at prices well below what ordinary investors would pay for them. In recent years, however, larger companies with more actively traded shares also have started using PIPEs. PIPEs also are advantageous to investors, who typically purchase securities at a discount to the market price, often in the 10% to 20% range, for relatively short-term investment. There is some liquidity risk, but effective due diligence minimizes investment risk. Risk may be offset further by hedging strategies. 3. PIPEs as a Significant Source of Capital According to Sagient Research Systems, 2006 represented a 39% increase over the 2005 total of $20.01 billion and a 14% increase over the previous one-year issuance record set in 2000 with $24.34 billion. Annual Deals - Since 1995 (All PIPEs - Excluding Structured Equity Lines and Canadian Companies) Year Deals Amount Through March 31, $14,355,809, ,338 $28,270,247, ,304 $20,010,059, ,270 $15,641,845, $12,632,749, $12,264,034, $14,604,527, ,106 $24,337,925, $10,258,789, $2,998,805, $4,747,221, $4,101,292, $1,334,025,

5 801 Total 9,518 $153,636,510,971 (Source: PlacementTracker.com at Top 10 Industries 2006 (All PIPEs - U.S. Based Companies) Rank Industry Amount Raised % of Total 1. Healthcare Products $2,728,950,612 11% 2. Pharmaceuticals $2,545,910,864 10% 3. Savings & Loan $2,417,069,940 10% 4. Biotechnology $2,376,062,375 10% 5. Oil & Gas $2,057,598,466 8% 6. Pipelines $1,657,696,460 7% 7. Healthcare Services $1,115,029,835 5% 8. Telecommunications $1,045,775,876 4% 9. Holding Companies $791,932,903 3% 10. Energy-Alternative Sources $748,187,424 3% Total $17,484,214,755 71% 4. Traditional PIPEs vs. Structured PIPEs Traditional PIPEs are generally attractive to issuers because in traditional PIPEs, investors bear the price risk from the time of pricing until the time of closing. Investors enter into a definitive purchase agreement with the issuer in which they commit to purchase securities (common or preferred stock, debt or convertible debt) at a fixed purchase price or fixed conversion ratio. By contrast, structured PIPEs often involve a sale of variable-priced securities (floating ratio convertible debt, for example) or a sale of securities accompanied by variable priced sweeteners, which often lead to death spirals. Conversion ratios depend on the performance of the underlying stock after the PIPE issuance. Structured PIPEs enable investors to convert their PIPE securities into a larger number of issuer shares if the issuer s stock performs poorly after the PIPE is announced publicly, thus effectively protecting investors against price declines. Structured PIPEs, therefore, might be subject to market manipulation by investors aggressively short selling the underlying equity shares during the conversion period, thereby driving down the price of the issuer s stock, and thus resulting in a more favorable conversion ratio. The strategy also - 3 -

6 802 can cause excessive dilution of other existing shareholders. Despite this potential death spiral, some issuers choose structured PIPEs because their financing options are severely limited. For companies with restricted access to the capital markets and limited financing choices, a structured PIPE is often a last resort. 5. SEC Interest in PIPE Hedging A frequent scenario in recent years of a PIPE transaction involving a hedging strategy is as follows: i. The issuer or its placement agent contacts investors about a potential PIPE transaction. Proposals may be shopped by different placement agents or among different investors or investor groups. ii. The investors borrow shares of the issuer and sell the shares short or hold the shares for the ability to sell them short in the future. iii. The documentation process begins. Throughout this period, the number and identity of the prospective investors may change. The terms of the investment may change as well. The issuer may cancel the PIPE altogether. The probability of a proposed PIPE being abandoned, restructured or offered to others on different terms remains substantial. iv. The transaction documents are signed and parties committed, money is wired and stock certificates are delivered. v. The PIPE is announced publicly. This may occur immediately after the closing or, if the closing occurs after the close of the market, before trading begins on the next morning. vi. If obligated to do so by the closing documents, the issuer files a registration statement, typically within 30 days of the closing. In some cases, shares are issued off the shelf to provide early liquidity. vii. The registration statement becomes effective, most often within 90 days of the closing. At this point, investors may dispose of their PIPE shares in open market transactions. Unassuming investors with preexisting short positions might think that the newly registered PIPE shares can be used to cover their short position; however, Section 5 of the Securities Act of 1933 ( Securities Act ) prohibits this practice, discussed infra. Thus, investors that need to cover short positions must sell the PIPE shares into the open market and cover the short positions with shares acquired separately in the - 4 -