Part XII: SEC Enforcement Trends And Priorities, 2008
Hedge funds have been a key enforcement priority since at least the time of the decision of the D.C. Circuit in Goldstein v. SEC, 451 F.3d 871 (D.C. Cir. 2006). There, the court vacated the SEC’s rule requiring hedge fund advisors to register. The SEC chose not to appeal.
Subsequently, Chairman Cox told Congress that “[h]edge funds are not, should not be, and will not be unregulated.” Testimony Concerning the Regulation of Hedge Funds (July 25, 2006).
Later that year, the SEC passed Rule 206(4)-8, an antifraud rule focused on hedge funds. The agency also began a series of cases against the funds involving private investment in public equity (“PIPE”) offerings – regulation through enforcement action.
As with most SEC enforcement actions, the hedge fund/PIPE cases typically settle. Three are in litigation, however.
The complaints in these case focus on a similar core of factual and legal allegations, although the precise facts in each case vary. Typically, the hedge fund participated in one or more PIPE offerings and traded in the shares of the issuer shortly before and/or after the announcement of the private placement component of the offering. In each case, around the time of the private placement component of the transaction, the hedge fund shorted the shares of the issuer and later, after the resale registration statement became effective, covered with the shares from the transaction. The covering shares were not registered at the time of the short sale, but were registered at the time of the covering transaction. Typically, the SEC complaint alleges the sale of unregistered securities in violation of Section 5 based on the short sale and insider trading in violation of Section 10(b).
Examples of hedge fund/PIPE which have settled include:
• SEC v. Spiegel, Civil Action No. 1:07CV00008 (D.D.C. Jan. 4, 2007), a settled civil injunctive action involving short selling in connection with a PIPE.
• SEC v. Friedman, Billings, Ramsey & Co., Civil Action No 06-cv-02160 (D.D.C. Dec. 20, 2006), 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 PIPE. The action was brought against investment banker Friedman, Billings, as well as its founder and Co-Chairman and its Director of Compliance.
Other cases have litigated. For example:
• SEC v. Lyon, Civil Action No. 06-CV 14338 (S.D.N.Y. Dec. 12, 2006). Here, the SEC alleged that the managing partner and chief investment officer of a group of funds engaged in an unlawful trading scheme with respect to 36 PIPE offerings by engaging in insider trading and the sale of unregistered securities. The court dismissed the Section 5 and related fraud claims in an opinion which was sharply critical of the SEC. Indeed, as to the SEC’s arguments on the Section 5 claims the opinion notes: “The Court finds this characterization of a short sale [by the SEC] inaccurate and not reflective of what occurs in the market.” Later, the court concluded that the SEC’s position was based on an “inherent logical implausibility.” The insider trading claims are in litigation.
• SEC v. Mangan, Civil Action No. 3:06-CV-531 (W.D.N.C. Dec. 28, 2006) is similar. Like Lyon, the complaint contained insider trading and Section 5 claims related to a PIPE. The court dismissed the Section 5 claims in an opinion which criticized the SEC. The SEC’s Section 5 clam was, in the Court’s view, nothing more than hindsight. The insider trading claim is in litigation, although the court expressed concern as to the viability of the claim.
• SEC v. Berlacher, Civil Action No. 07-cv-3800 (E.D. Pa. Sept. 13, 2007). The complaint here is similar to Lyon and Mangan, alleging insider trading and Section 5 violations related to a PIPE. Again, the court dismissed the Section 5 claim. The insider trading claim is in litigation. See also SEC v. Colonial Investment Management LLC, Civil Action No. 07-Civ-8849 (S.D.N.Y. Oct. 15, 2007) (similar allegations to other cases except the short sale violations are based on Rule 105 which prohibits short sales within 5 days of an offering; the case is pending).
Next: Backdated options