Saturday, August 26, 2006

PIPEs Financing and D & O Risk

A casual reader of the New York Times business page or the Wall Street Journal might well get the impression that PIPEs (private investments in public equity) financing transactions are the devil’s own handiwork. Both publications have recently run stories fraught with dire tones and ominous insinuantions about PIPEs transactions. The New York Times August 13, 2006 article (here, registration required) entitled “Secrets in the Pipeline” is a particularly egregious example. The D & O Diary is concerned that this perspective on a type of financing that is becoming increasingly popular could lead to the inaccurate and unwarranted perception that companies involved in PIPEs financings all belong in a particularly suspect risk class. While there are PIPEs transaction characteristics that could well suggest larger problems, there is nothing inherent about a PIPEs financing transaction that should cause a company resorting to this type of financing to be viewed with suspicion.

PIPEs transactions typically are structured as a minority investment in a publicly traded company. PIPEs offer accredited investors the opportunity to acquire company securities at a discount to the securities’ market value. The issuer undertakes to register the PIPEs securities with the SEC, usually within 90 to 120 days of the transaction closing. There are two main types of PIPEs, traditional and structured. In a traditional PIPE, the company issues common or preferred stock at a set price. In a structured PIPE, the company issues debt securities that are convertible into common or preferred shares according to a conversion ratio that may vary.

PIPEs are an established part of the financial landscape. In 2005, there were a total of 1,301 PIPEs transactions, worth $20 billion. As of August 2006, there have already been nearly 800 PIPEs transactions worth $18 billion.

A PIPE transaction offers the issuing company certain advantages compared to other capital raising alternatives:

• Flexibility: SEC registration is not required prior to offering or closing;
• Transaction Size: To complete a secondary offering, investment bankers and investors require a minimal transaction size, roughly $ 75 mm or more. A company that needs a lesser amount, or that is simply too small to engage in a transaction of that size, has greater flexibility with a PIPEs transaction;
• Efficient Use of Management’s Time: The preparation required for a PIPE is minimal compared to a secondary offering, and there is no need for management to become involved in roadshow meetings, etc.

PIPEs do have downsides for the issuing company. PIPEs are dilutive of existing shareholders’ equity interest, but so too are secondary offerings. PIPEs may also attract short term investors whose interests may not align with those of management or other shareholders, as discussed below.

Investors are attracted to PIPEs for a number of reasons:
• Discount Pricing: Issuers offer securities as a modest discount (5% to 25%) to the market value, in light of the initial illiquid nature of the securities before the registration process is complete;
• Public Market Liquidity: Once the registration process is complete, investors can sell into the public market;
• Speed to Closing: Since the company is already public, extensive information is already available and there is no SEC registration process before closing.
There are disadvantages for investors, primarily because a PIPE transaction usually involves only a small stake in the company. Investors do not acquire a sufficiently large stake to be able to control the company’s board or the timing or outcome of major corporate decisions.

History may explain part of the reason PIPEs are often viewed with suspicion. PIPEs transactions have been known as “death spiral” or “toxic” offerings, primarily as a result of PIPEs transactions completed during 2000 and 2001, when the declining stock markets made it difficult or impossible for many companies to raise money through secondary offerings. During that period, companies conducting PIPEs by issuing convertible preferred securities where the conversion ratio changed based on the company’s share price. Companies found that investors had every incentive to drive down the company’s share price after closing so that investors could get more company shares upon conversion. Many of these transactions ended badly for the companies involved, and indeed for investors as well. The wreckage from that era has been cleared, and structured PIPEs now represent a much smaller portion of the market, and usually incorporate mechanisms (caps, floors, etc.) to remove or minimize incentives for investors to push shares down.

Another reason PIPEs may be viewed with suspicion these days is that the PIPEs investors increasingly are hedge funds. Hedge funds buying securities in a PIPE are not acquiring a controlling ownership position, so their opportunity to gain from the transaction is not dependent on a restructuring or a management change; the investors must make profits from the transaction itself. So many hedge funds will “hedge” their position by selling the company’s stock short, to ensure gains even if the company’s shares decline. This understandably may make many managers and existing shareholders uneasy because of the hedge funds’ mixed motivations. Companies can set contractual limits around the timing or amount of investors’ short selling, but that typically will come at the price of a larger discount on the securities offered in the PIPE transaction.

The complicated and potentially conflicted role of the PIPE investor is clearly of concern to the SEC, and in recent months there have been several SEC enforcement proceedings focused on PIPEs investors’ activities:

• In March 2006, the SEC settled with three hedge funds and their portfolio manager for alledgely engaging in “naked” short sales, whereby the shorted shares in PIPEs transactions without actually borrowing publicly traded shares to cover their short position. (Short sellers cannot cover their short position with securities acquired in the PIPE transaction because they are not publicly available shares during the pre-registration period.) One of the hedge funds also shorted the company’s shares before it was publicly known that the company sought to raise money in a PIPE transaction. A copy of the SEC’s press release on this action can be found here.
• In May 2006, the SEC settled an enforcement action against a hedge fund advisor and its portfolio manager for trading in the shares of 19 companies based on information that the companies were about to announce PIPEs transactions. A copy of the SEC’s press release on this action can be found here.

These and other SEC enforcement actions (which can be found here and here) generally are focused on investors’ conduct or the conduct of the broker handling the PIPE transaction, rather than the conduct of the issuing company. At least recently, the problems have not involved the issuing companies.

To be sure, there are transaction attributes that can justify wariness of companies engaged in PIPEs transactions:

• Reset or variable rate PIPEs: These types of transactions are still getting done, but they are clearly riskier deals. The riskiest of all are transactions that lack or have insufficient caps or floors on the conversion ratio for convertible securities, because these transactions hold the “death spiral” potential. It is unlikely that any company that has other financial options would enter a transaction of this type.
• Officers or directors buying shares in a PIPE transaction: This is obviously a problem – shares are being offered at below market values in a transaction that is not public knowledge until after closing. At a minimum, it raises the possibility of self-dealing or conflicts of interest (for example, in setting the level of the discount), and it raises concerns about shareholder approvals as well.
• Excessive discount: Discounts for PIPEs securities typically are modest, in the range of 5 to 25%. Discounts at a level greater than this suggest desperation or the existence of some other problem with the transaction.

So the picture with respect to PIPEs can be complex. But companies engage in these transactions for important and legitimate reasons, and therefore PIPEs are likely to remain an important part of the financial landscape. Clearly, the many companies engaged in these transactions cannot be treated as suspect simply because they have resorted to PIPEs financing. A company that has completed a PIPE should not be treated as a suspect D & O risk simply because of the PIPE. As noted above, there are features that could make a PIPE transaction riskier, but in the absence of those characteristics, a PIPE transaction alone should not make the company a suspect D & O risk.

A particularly good short summary on about PIPE financing can be found here. A more academic (and slighly dated) overview can be found here.

A good brief examination of a single company's motivations and experience with PIPE financing can be found here.

Professor Larry Ribstein also has a post (here) on his Ideoblog that is critical of the New York Times' article about PIPE mentioned above.

Options Backdating Litigation Update: The D & O Diary's list of options backdating lawsuits (here) has been updated to add the new securities fraud lawsuit that has been filed against Apple Computer (here) and certain of its directors and officers alleging misrepresentations and omissions in its SEC filings and proxy statements about the company's alleged stock options practices. The addition of the Apple lawsuit brings to 15 the total number of companies sued in purported class action securities fraud lawsuits alleging options timing manipulations.

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