PIPEs Can Be Dangerous To Your Health

Wednesday, October 29, 2003

Leib Lerner, Abstracted from: Disclosing Toxic PIPEs: Why The SEC Can And Should Expand The Reporting Requirement, http://

Better Business Management & Planning Practices

Business Lawyer - Vol. 58, No. 2, Pgs. 655-688

Overview:
Addresses the danger posed by predatory investors making private investments in public equity. Argues that these PIPEs should be subject to SEC reporting, and explains how the original shareholders can avoid losing the company to short-term PIPE investors.

Traditional PIPEs.
Private investments in public equity (PIPEs) are increasingly popular. PIPEs afford issuers the rapidity, certainty, and low costs of a private offering, while the PIPE investors stand assured of ending up with registered, freely resellable stock. With a traditional PIPE, Leib Lerner explains, investors agree to buy a public companys securitiesusually convertible preferred sharesin a private placement, provided that a registration statement permitting open-market resale of the common shares they receive at conversion becomes effective within a specified time. A careful issuer can avoid integrating the two offerings. Investors experience only brief illiquidity, since registration goes quickly for an already-public issuer, and they get favorable terms: an unlimited reset provision, which adjusts the final conversion price to a specified percentage below the common shares' market price on the conversion date; a discount of generally 10% to 30% on the price of the common shares; and sometimes a seat on the board.

PIPEs of a different color.
What has come to be known as the toxic convert or death spiral PIPE is a horse of a different color. Predatory investors can bankrupt the issuer with a toxic PIPE, leaving the issuer and the original shareholders with nothing while the PIPE investors head to the bank. A reset provision allows them to benefit if the common shares go into a devaluation tailspin, which they in fact instigate by selling large blocks short. Even if the common shares lose all value, the author notes, the PIPE investors make a profit by covering their short positions with the common shares they receive upon conversion. Should the issuer somehow survive, the reset provision plus the discount might give the predator enough common shares to control the issuer, which can then be liquidated or sold to the highest of the bidders attracted by the reduced share price.

Disclosure is in order.
The SEC's disclosure rules do not apply to PIPE investors, but, the author argues, they should. Rule 13d-1 under the 1934 Act requires anyone who becomes the beneficial owner, whether direct or indirect, of over 5% of an equity security to file Schedule 13D. A beneficial owner is any person who possesses voting power, investment power, or both of a security, whether directly, indirectly, due to a contract or relationship, or in any other way. The definition encompasses someone who has the "right to acquire beneficial ownership" within 60 days by exercising an option or right or by converting another security. Arguably, a PIPE investor who sells short is indirectly acquiring ownership of the issuer's equity securities, due to the reset provision. Rule 13d-1 should therefore apply when any such short sale puts the investor's ownership over 5%; when a short sale gives an additional 1% to an investor already over 5%; or when the investor can convert to common stock within 60 days after selling short. Requiring Schedule 13D from a PIPE investor would enable other shareholders to reach informed decisions about selling their stock, holding it, or purchasing more.

Fight back.
According to the author, four strategies have successfully averted toxic PIPEs. One is to establish a floor for the reset provision that removes the incentive to sell short. The company could also buy the PIPE investors out by selling new shares to other private investors, assuming the rest of the shareholders agree to accept the resulting dilution. The rare company that survives the toxic PIPE transaction could sue the PIPE investors, alleging fraud and unlawful manipulation of the market, and try to force a settlement in which it buys them out. Alternatively, the company's first venture capitalists might agree to salvage their investment by making an additional one, perhaps persuading other private investors to join in a PIPE without an onerous reset provision.

Abstracted from The Business Lawyer, published by American Bar Association, Section of Business Law, 750 N. Lake Shore Drive, Chicago, IL 60611

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