Unique Theory on Sale of Unregistered Securities – Investment Banker’s Short Sales Prior to a PIPE Offering

Wednesday the SEC filed a settled civil injunctive action alleging insider trading, selling of unregistered securities, and failure to supervise in connection with CompuDyne Corporation’s sale of a Private Investment in Public Equity (“PIPE”) against Northern Virginia investment banker Friedman, Billings, Ramsey & Co.; its founder and Co-Chairman and Co-Chief Executive Officer, Emanuel Friedman; Director of Compliance, Nicholas Nichols; and Head Trader, Scott Dreyer. In the settlement, FBR consented to pay $3,755,839. Messrs. Friedman and Nichols consented to pay $754,046 and $60,000, respectively. The three defendants also consented to the entry of SEC orders censuring FBR and Dreyer, requiring Dreyer to pay $19,870, and ordering the firm to comply with certain undertakings. Mr. Friedman consented to an order barring him from association in a supervisory capacity with a broker or dealer with a right to reapply for association after two years. Friedman Billings has served as a key investment banker to the Northern Virginal high tech community.

See SEC v. Friedman, Billings, Ramsey & Co., Inc. et. al., Civil Action No. 06-cv-02160 http://www.sec.gov/litigation/litreleases/2006/lr19950.htm, http://www.sec.gov/litigation/complaints/2006/comp19950.pdf; see also In the Matter of Scott E. Dreyer, Administrative Proceeding File No. 3-12510 http://www.sec.gov/litigation/admin/2006/33-8761.pdf. In a PIPE offering a placement agent or underwriter, such as FBR, places restricted shares of a public company (CompuDyne) with accredited investors who have executed a purchase agreement with the public company. As part of the arrangement the public company agrees to file a resale registration statement within a specific time so the investors can sell the shares to the public. The investors do not pay for the shares until just before or after the resale registration is effective.

According to the SEC’s complaint, CompuDyne’s shares were traded thinly at the time of the PIPE offering. In advance of the resale, information flowed from the investment banking and sales side of FBR to the trading side without restriction. The trading department, based on information from the offering, sold CompuDyne shares short with the intent to cover from shares purchased in the resale from firm clients. According to the complaint, the PIPE offering information was material non-public information and, thus, trading on that information is insider trading in violation of the antifraud provisions of the federal securities laws. At the same time, permitting the information about the offering to flow out of the investment banking and sales arm of FBR constituted a failure to supervise and have appropriate procedures in place. The sale of unregistered securities occurred because FBR sold CompuDyne’s shares short prior to the actual resale, although the shares of the company were publicly traded. The SEC tied this claim to factual allegations that the short sales were made with the intent of, and in fact were, covered with shares from the resale – i.e. shares that had not yet been part of a public offering and were restricted at the time of the short sale. The approach of this complaint is interesting and worth considering. The insider trading claim is based on the theory that CompuDyne shares were part of a trading market. Thus, an insider – or temporary insider such as FBR – who has material non-public information and trades based on that information violates the antifraud rules. This is textbook insider trading. Similarly, standard industry practice dictates that an investment bank should prohibit information flow from its investment banking and sales operations to its sales arm. Yet, what is interesting is the theory of the Section 5 sale of unregistered securities claim. The Section 5 claim is based on the theory that the short sales were made prior to the effective date of the resale registration statement for the then restricted PIPE shares. At the time of those short sales, however, there was a trading market for CompuDyne shares. Since the short sales could have been covered from that market one could argue that there was no Section 5 violation. The SEC appears to have avoided this difficulty by integrating the short sales into the resale. This is done with two key factual allegations: (1) a claim that CompuDyne’s shares were traded very thinly suggesting that the shorts could not be covered (at least easily) from the market; and (2) a specific allegation that the shorts were made from FBR’s market maker account and would be, and in fact were, covered by purchases in the resale aftermarket from firm clients. Thus, the SEC claimed in its complaint that “FBR and Friedman, in effect, sold their customers’ PIPE shares prior to their registration.” These allegations suggest that FBR violated Section 5 and took unfair advantage of its clients. The SEC’s Section 5 claim, which might at first appear very questionable, ties together based on the factual allegations. In contrast, if the short sales were made and covered on an exchange the theory would clearly be problematic at best.