Tougher Oversight Looms For Hedge Funds Investing In PIPEs

Law360 (December 4, 2020, 4:13 PM EST) --
Perrie Weiner
Perrie Weiner
Aaron Goodman
Aaron Goodman
Ben Turner
Ben Turner
Jay Clayton, the chairman of the U.S. Securities and Exchange Commission, has announced he would be stepping down at the end of the year.

A veteran corporate lawyer who spent decades at Sullivan & Cromwell LLP before being tapped by the Trump administration, Clayton championed deregulation during his nearly four-year tenure at the SEC. Under his watch, Clayton pushed through rulemaking amendments to promote capital formation in private markets by scaling back disclosure requirements and easing registration requirements.

During his tenure, the SEC also adopted changes to make more individuals eligible as accredited investors. Many criticized Clayton for loosening financial industry protections, being too business-friendly, and prioritizing increased public offerings that diminished safeguards for retail investors.

A dramatic shift in the SEC's priorities, however, is now looming as the incoming Democratic administration will surely bring back stricter oversight. Among the names being floated as Biden's appointee are Gary Gensler, who led the Commodity Futures Trading Commission during the Obama administration, and was an aggressive regulator who spearheaded new rules that strengthened the Dodd-Frank regulatory scheme. Whoever replaces Clayton, however, a tougher enforcement hand by the SEC is all but assured.

Under a Biden appointee, we anticipate that the SEC will likely ramp up enforcement actions in an area that regulators have long believed was particularly susceptible to fraud and abuse: penny stocks. Even under Clayton, the SEC had already begun to bring aggressive enforcement actions against perceived abuses by convertible debt investors in microcap stocks.

In a relatively new tactic intended to curb microcap lenders from dispersing billions of newly issued shares into the market, the SEC began to take an exceedingly expansive view of what it means to be a dealer for purposes of Section 15(a) of the Securities Exchange Act. These recent enforcement actions — and favorable opinions by district courts siding with the SEC — will only pave the way for a new spate of Section 15(a) actions under the Biden administration.

Investors should not only expect the pace of such enforcement actions to increase. They should also expect, as Biden takes a more aggressive stance toward Wall Street, for regulators to bring Section 15(a) enforcement actions against a broader range of transactions. Hedge funds could be among those targeted.

Under Clayton, Section 15(a) enforcement actions have largely been limited to convertible debt transactions between lone investors amassing billions of discounted shares in dozens of different microcap issuers. SEC enforcement under the new Democratic regime may soon set its sights on private investments in public equity, or PIPE, transactions which, at least superficially, bear many similarities to the transactions targeted by Clayton.

A PIPE is an important tool for public companies seeking to raise capital quickly, and involves a private placement of securities in an already public company with accredited investors.

Ultimately, however, there are substantial and material differences between most PIPE transactions and the investment activity at issue in cases in Section 15(a) enforcement actions under Clayton. In the end, these differences will pose significant challenges for the Biden administration if it begins to target investors in PIPE transactions as unregistered dealers.

Who is a dealer under the Exchange Act?

Whether a person is a dealer is a fact-specific inquiry that turns on two questions: (1) whether a person is "buying and selling securities for its own account," and (2) whether a person is engaged in that activity "as part of a regular business."[1]

As to the first element, the phrase "buying and selling securities for such person's own account" simply means purchasing or selling securities as a principal. As to the second element, Section 15 of the Exchange Act does not define the phrase "engaged in the business," but various courts have described the conduct that constitutes being "engaged in the business" of "effecting transactions in," or "buying and selling," securities.[2]

In short, the definition is exceedingly broad, and Biden's appointee will wield enormous power on how to interpret and enforce Section 15(a) while rolling back Clayton's deregulatory approach.

For proponents of stronger regulation, Section 15(a)'s dealer registration requirement is a powerful tool to crack down on unregistered penny stock offerings.

Even in spite of Clayton's more hands-off approach to enforcement, just this year, the SEC brought three unregistered dealer claims:


All three cases involved the allegation that the defendants acquired convertible debt from microcap companies, converted that debt into stock, and then rapidly sold the converted shares to the public at a significant profit. And in all three cases, the central alleged violation is the same — that the defendants failed to register as dealers with respect to the resale of newly issued penny stock.[3]

Taken together, the pleadings in these cases include several similarities, that inform, at least in part, what drove the SEC to take enforcement action. All of the cases make allegations that the defendants:

  • Participated in an offering of penny stocks by buying newly issued shares and reselling the securities;

  • Bought and sold billions of shares and from a high number of issuers;

  • Acquired the securities at a significant discount;

  • Engaged in significant promotional activities related to the buying and selling of securities; and

  • Did not register their offerings.

Hedge funds should distinguish registered PIPE transactions from the transactions targeted in enforcement actions such as Fife, Fierro and Keener.

Because there is no bright-line list of factors for determining whether an individual or entity is acting as a dealer, aggressive regulators will likely turn to Section 15(a) as part of a broader effort to bring back stricter oversight of the financial industry.

The dealer inquiry is fact-intensive, and as one district court observed last year, even the SEC's published guidance factors are "neither exclusive, nor function as a checklist through which a court must march to resolve a dispositive motion."[4] Rather, "whether and which are met is necessarily a fact-based inquiry best reserved for summary judgment or trial."[5]

Hedge funds are right to be anxious. There is certainly overlap between PIPE transactions and the activities engaged in by the defendants subject to these SEC enforcement actions. But there are several critical distinctions that hedge funds should amplify in the event that they find themselves in the SEC's crosshairs.

First, although market participants may purchase convertible notes directly from small-cap public companies in PIPE transactions, the number of issuers and volume of shares is likely significantly less than the SEC defendants. For instance, in Fife, Fierro and Keener, the defendants allegedly purchased convertible notes from dozens of different issuers, and then sold billions of newly issued securities.

Second, investors in PIPE transactions typically do not advertise, sponsor or promote on a website, or attend conferences, to attract public issuers or to create a market to resell newly issued securities. In Fife, Fierro and Keener, the defendants allegedly advertised to issuers, engaging in cold calls, and even hired salespeople who worked on commission to find new issuers.

Third, none of the SEC defendants filed a registration statement, while many PIPE transactions are registered with the SEC.

Finally, most — if not all — of the SEC defendants rapidly sold off their converted shares to generate a quick profit. In many PIPE transactions, investors agree to a lockup restricting their ability to sell the securities for a period of time after investment. And the lockup agreements may include limitations on the volume of shares that may be sold once the lockup period expires.

Some investors may query whether large scale private placements in convertible debt comply with Section 15 if the trades are run through a registered broker-dealer. The short answer is no.

An investor acquiring convertible debt and then quickly selling millions or billions of shares through a broker-dealer would still trigger Section 15 liability because the investor would still be the party engaging in dealer activity. Indeed, in Keener, the defendant specifically sold his stock through brokers, and yet was still charged with a Section 15 violation.

Hedge funds can take steps to reduce their risk profile.

Because the potential reach of Section 15(a)'s dealer registration requirement is exceptionally broad, and that reach is certain to expand under the Biden administration, hedge funds would be well-advised to distance themselves from the investment activity at issue in the SEC's recent enforcement actions.

Critical to that is a resale registration statement — if an investor is buying securities in a PIPE offering, where there is a resale registration statement filed by the issuer and a lock-up agreement, and a registered broker-dealer is acting as an underwriter, there is a significant difference from an enforcement perspective.

That is further true if the investor is not engaged in related solicitation, marketing or promotion. It may not ultimately change the pure legal determination of whether a particular investor is, in fact, engaged in the business of buying and selling securities for its own account, but it would change the enforcement risk profile.

For that reason, where there is a registration statement filed for the resale, it would significantly change the case from an enforcement policy perspective, and it is unlikely to be a violation that the SEC would pursue for enforcement. Rather, the Section 15(a) claims, when viewed through the SEC's lens, appear to touch on distribution-type conduct consistent with dealer or underwriting activity.

Other measures hedge funds can take include:

  • Avoid purchasing toxic or floorless convertible debentures from ultra-low microcap companies trading on over the counter markets.

  • Conduct in-depth analyses, including into the company's long-term earnings, asset value and cash flow, to support the investment process and to evaluate the issuer's viability as a long-term investment.

  • Conduct quantitative and fundamental research on each issuer to analyze credit quality and the specific terms of each offering, and estimate the probability that the principal amount of the fixed-income component of the debenture will be repaid upon maturity.

  • Seek to earn trading profits based on interest income from the debenture and capital appreciation of the issuer's stock, rather than relying solely on deep discounts on the stock price negotiated with the issuer.

  • Maintain equity and convertible debt positions for longer time periods, rather than converting the debt and selling shares as soon as the holding period ends.

But regardless of the measures hedge funds take, enforcement actions and increased regulatory scrutiny are all but guaranteed to increase. And the potential, sweeping breadth of Section 15(a) makes it an ideal enforcement tool for a Democrat-controlled SEC.

Hedge funds participating in PIPE transactions should determine if their current business model runs afoul of Section 15(a), and then take a comprehensive review of their investment activity and identify concrete steps they should take to ensure compliance with the SEC's dealer registration requirements.



Perrie Weiner is a partner and chair of the North America securities litigation group at Baker McKenzie.

Aaron Goodman is of counsel at the firm.

Ben Turner is of counsel at the firm.

Kirby Hsu, an associate at the firm, contributed to this article.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.


[1] 15 U.S.C. § 78c(a)(5)(A).

[2] SEC v. Helms , No. A-13-CV-01036 ML, 2015 U.S. Dist. LEXIS 110758, at *50 (W.D. Tex. Aug. 21, 2015).

[3] Fierro and Keener were both investigated by same SEC staff -- Antony Richard Petrilla, Hope Hall Augustini, and Joshua Braunstein and supervised by Brian O. Quinn and Carolyn M. Welshhans. The litigation in both matters was similarly led by Messrs. Braunstein and Petrilla and supervised by Jan Folena.

[4] United States Sec. & Exch. Comm'n v. River N. Equity LLC , 415 F. Supp. 3d 853, 858 (N.D. Ill. 2019).

[5] Id.

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