On Thursday, January 4, 2006, the SEC filed another settled civil injunctive action involving short selling in connection with a PIPE offering. SEC v. Joseph J. Spiegel, Civil Action No. 1:07CV00008 (RCL) (D.D.C.) http://www.sec.gov/litigation/litreleases/2007/lr19956.htm.  Last month the SEC brought and action against Friedman Billings & Ramsey and certain officers of that company alleging violations of the registration provisions of the Securities Act by entering into a contract to purchase securities in a PIPE offering, selling those securities short, and then covering the short position with the shares acquired in the PIPE offering once the resale registration statement became effective.  See blog posting December 22, 2006 “Unique Theory on Sale of Unregistered Securities – Investment Banker’s Short Sales Prior to a PIPE Offering”; see also SEC v. Friedman, Billings, Ramsey & Co., Inc. et. al., Civil Action No. 06-cv-02160 http://www.sec.gov/litigation/litreleases/2006/lr19950.htm; In the Matter of Scott E. Dreyer, Administrative Proceeding File No. 3-12510 http://www.sec.gov/litigation/admin/2006/33-8761.pdf. 

Last week, the SEC brought an action against Joseph Spiegel, former portfolio manager for Spinner Asset Management, LLC, an investment advisor to hedge fund Spinner Global Technology fund, Ltd. (The SEC brought a related action against Spinner on December 20, 2006 http://www.sec.gov/litigation/admin/2006/33-8763.pdf).  Following the pattern set forth in the Friedman Billings case, the SEC’s complaint alleged that the trader and hedge fund entered into contracts to purchase shares in a PIPE offering and then sold those shares short.  The complaint claims this violates Section 5 because the trader and Fund intended to cover the short position with shares acquired in the PIPE offering once the resale registration statement became effective.  The trader and Fund attempted to hide their conduct by engaging in basically wash sales and making false statements in entering into the PIPE agreement.  In that agreement they stated that they were not acquiring the shares for redistribution.  

According to SEC, the key to these transactions is linking the short sale to the shares acquired in the PIPE offering.  The Order for Proceedings naming the Fund states: “Many PIPE investors ‘hedge’ their investment by selling short the PIPE issuer’s securities before the resale registration statement is declared effective.  There is nothing per se illegal about ‘hedging’ a PIPE investment by selling short the issuer’s securities.  Such short sales do not violate the registration provisions of the Securities Act if, among other things, the investor closes out the short position with shares purchased in the open market.  An investor violates Section 5 of the Securities Act, however, when it covers its pre-effective date short position with the actual shares received in the PIPE.  This is because shares used to cover a short sale are deemed to have been sold when the short sale was made.”  Stated differently, the basis for the Section 5 violation is the intent by the short seller at the time of making the short sale to cover with securities acquired later, despite the fact that at the time of the cover transaction the shares were registered.  

The SEC’s position in these cases is particularly interesting in view of its current rules and rule making activity.  Presently Rule 105 under Regulation M prohibits a trader from selling short after the filing of a registration statement but prior the effective date.  Rule 105 is an anti-manipulation rule based on the theory that “by selling the security short with the knowledge that they are very likely to be able to cover their short positions with offering shares that they are allocated, these persons may drive down the price despite their true belief regarding the appropriate price for that security.  The likelihood of being allocated offering shares provides these persons with an advantage over other persons, which they may exploit to the detriment of pricing efficiency.  Not only is this conduct harmful to the market and current security holders, but it can reduce the proceeds the issuer or the selling security holder receives from the securities offering.”  Exchange Act release No. 34-54888 at 7 http://www.sec.gov/rules/proposed/2006/34-54888.pdf  As that Release makes clear, the SEC has brought a number of enforcement actions based on alleged violations of Rule 105. 

Presently the SEC is soliciting comments on amending Rule 105 to eliminate various schemes used to try and circumvent the Rule.  In the rule making Release, the SEC solicited comments on whether Rule 105 should be amended to cover situations such as the Friedman and Spinner cases:  “Should the Rule [105] address short sales effected during the period following the entry into of a PIPE transactions and before a registration statement for resale of the restricted securities acquired in the PIPE transaction is declared effective, or short sales that are effected at any time in connection with the PIPE transactions?”  Exchange Act release No. 34-54888 at 17 http://www.sec.gov/rules/proposed/2006/34-54888.pdf.  Clearly Rule 105 does not presently prohibit such transactions.  Rather, the current enforcement cases are dependent on the intent of the short trader to cover with shares from the PIPE transaction.  Yet, as the SEC noted in the Order for Proceedings in Spinner, hedging a PIPE investment is a standard practice.  The only difference between the valid PIPE hedge and one which violates Section 5, according to the SEC, is the trader’s intent, linking the hedge to the cover.  Since there is no harm to the market from hedging a PIPE investment and there is an effective registration statement giving the market all material facts about the PIPE shares at the time the short sale is covered, the SEC’s position seems to emphasize form over substance. This circular argument is akin to former President Jimmy Carter’s lust in his heart comment.  [“Christ said, I tell you that anyone who looks on a woman with lust has in his heart already committed adultery. I’ve looked on a lot of women with lust.” Jimmy Carter interview, Playboy, Nov. 1976]

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On Friday, December 29, 2006 Apple Computer filed its delinquent 10-K and 10-Q reports, restating certain results and taking a non-cash charge of $84 million related to its improper stock option transactions.  The reports reiterate the conclusion  of a Special Committee headed by Al Gore which found no misconduct by current management but serious questions about the conduct of two prior officers.  The reports also acknowledge that the company’s founder and CEO, Steven Jobs, “was aware or recommended the selection of some favorable grant dates [but] he did not receive or financially benefit from these grants or appreciate the accounting implications.”  The reports detail a number of errors in the option granting process. 

No doubt Apple hopes that completing its stock option probe and filing its SEC reports is the end of the matter.  New reports, however, suggest otherwise.  According to BusinessWeek.com, The Recorder, a trade journal in San Francisco, claims that federal investigators are looking into the question of whether Apple may have falsified documents in connection with improper stock option grants.  A report by the Financial Times also raises questions about the extent to which Mr. Jobs’ reputation may be harmed by the matter.  According to the Financial Times, a few day before Apple introduced the iPod music player on October 23, 2001, Mr. Jobs was given 7.5 million options without the required authorization of the company’s board and at a near low point for the stock.  Later when these options were underwater following a stock split, Mr. Jobs surrendered them and received restricted stock.. http://www.ft.com/cms/s/801e1b82-9605-11db-9976-0000779e2340.html 

The issuance of these options appear to coincide with those detailed in Apple’s SEC filings, which were recorded improperly as having been approved at a board meeting that did not take place.  According to Apple’s SEC filings on Friday, one set of improperly issued options had a grant date of October 19, 2001.  This grant was approved originally at a Board meeting on August 29, 2001 with an exercise price of $17.83.  The terms of the grant were not finalized until December 18, 2001.  The grant ,however, was dated October 19, 2001 with an exercise price of $18.30.  According to Apple, the “approval for the grant was improperly recorded as occurring at a special Board meeting on October 19, 2001.  Such a special Board meeting did not occur.  There was no evidence, however, that any current member of management was aware of this irregularity.” 

Although Apple claims it is continuing to cooperate with the DOJ criminal and the SEC civil investigators, it is unclear if cooperation will be sufficient to forestall charges.  Questions have been raised since the beginning concerning Apple’s handling of the matter.  When Apple initially learned it might have stock option problems and received requests for information from the government, the company chose not to disclose the matter for months.  Later when it did disclose the matter the company stated that it had no obligation to make any earlier disclosure.  As we noted in an earlier entry in blog, that is an accurate statement of the law.  Whether it is the best shareholder relations or evidences cooperation has yet to be seen.  See Blog entry 9/5/06 “A Difficult Choice: “To Disclose Or Not To Disclose” an SEC Investigation.”

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