Disturbing Questions About the SEC’s Enforcement Program

Earlier this month the SEC lost another key ruling involving short sales, PIPE offerings and hedge funds. Losing a court ruling is not necessarily news worthy. What is significant, however, is that not only did the SEC lose another ruling on its claims that a hedge fund engaged in fraud and the sale of unregistered securities by selling an issuer’s stock short after entering into a PIPE offering, but that for the second time in this series of cases the Court criticized the agency for a lack of candor in arguing its position.

In SEC v. Lyon, Civil Action No. 06 CV 14338 (S.D.N.Y. Filed Dec. 12, 2006), the Commission brought an action against the managing partner and chief investment officer of a group of funds. The action is one of a series of similar cases discussed here.

In Lyon, the complaint alleged that the defendant engaged in an unlawful trading scheme between 2001 through 2004 from which they realized more than $6.5 million in ill-gotten gains by investing in 36 PIPE offerings without incurring market risk. Specifically, the complaint alleged that the defendants entered into PIPE offerings which required them to keep the offering confidential, sold the securities of the issuer short and later covered the short position with the shares from the PIPE after the resale registration statement became effective. Based on these allegations, the SEC alleged insider trading, fraud in connection with the offerings and the sale of unregistered securities.

In a January 2, 2008 Judge Sidney H. Stein in the Southern District of New York granted in part defendants’ motion to dismiss. First, the court declined to dismiss the insider trading claims. Defendants argued that the SEC failed to properly allege a confidential relationship which is the predicate for an insider trading claim. While the SEC pointed to language in the offering documents requiring participants to maintain the confidentiality of the transaction, defendants denied that this provision was in the documents they executed. In refusing to dismiss these claims the court noted that at this stage of the proceeding the SEC’s allegations were sufficient. At the same time, the court made it clear that this issue would be critical later in the case.

Second, the court dismissed with prejudice the SEC’s claims of fraud and sale of unregistered securities. These claims were based on the SEC’s theory that, at the time of the short sale, the defendants effectively sold the shares of the issuer which they would later obtain after the resale registration statement became effective. Since the resale registration statement was not in effect at the time of the short sale, the SEC argued that defendants’ sold unregistered securities. By making the short sale at the time of entering into the transaction, the SEC also argued that defendants falsely represented that they had the requisite investment intent in entering into the private placement portion of the transaction (PIPE transactions are discussed here).

In rejecting the SEC’s argument the court held:

“According to the SEC, the means that an investor uses to close his short position determines what security was actually sold when the short sale was executed. Consider an investor who shorts the common stock of a company and then covers his short position by converting convertible bonds into the common stock owned. Under the SEC’s theory, that investor sold convertible bonds – not common stock – through his short sale. The Court finds this characterization of a short sale inaccurate and not reflective of what occurs in the market. Indeed, the buyer on the other side of that hypothetical short sale received common stock, not convertible bonds. Accordingly, from 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 definite in his trading account [from the short sale] does not alter the nature of the sale.”

The court went on to note that not only was the SEC’s position based on an “inherent logical implausibility,” but it also “does not advance the purposes that animate section 5’s registration requirement.” In making this ruling, the court rejected the SEC’s claim that a series of its administrative releases supported its position, finding that “the SEC quotes selectively – and in the Court’s view misleadingly …” from them.

This is not the first lost on this theory the SEC has suffered. As discussed earlier here, the court in SEC v. Mangan, Civil Action No. 3:06-CV-531 (W.D.N.C. Filed December 28, 2006) made a similar ruling. In that case, as in Lyon the court chastised the SEC for its lack of candor.

What is most disturbing about these cases is not the fact that the SEC lost. To be sure there are inherent difficulties with the legal theory on which the agency is basing its fraud and Section 5 claims in these cases, as Judge Stein pointed out. No doubt the SEC should have carefully evaluated those difficulties before bringing an enforcement action. An enforcement action, as the SEC well knows, should be brought to enforce the law, not try out novel theories. This is particularly true in view of the impact caused by a government accusation of wrongful conduct.

The most disturbing aspect of Lyon however, is that it is the second time in these cases that a court has criticized the SEC for a lack of candor. There simply is no excuse for such conduct by any litigant. This is particularly true of a government agency such as the SEC. The SEC cannot enforce the law by slight of hand. Such tactics compromise not only the SEC’s distinguished reputation, but also undermine its ability to monitor the market place in accord with its statutory duty.

In addition, the repeated use of improper tactics in making the same argument against similar defendants involving similar facts suggests that perhaps something more is at work in these cases than meets the eye. Regardless, it is time that the SEC not only reconsider the legal theory in these cases, but also its tactics. It simply will not due for courts to continually criticize the agency for a lack of candor.