The PIPEs Report, a weekly publication put out by DealFlow Media, found that PIPE deals have raised over $1 billion per week on average for 2007. This type of lending activity has grown once again after a couple of lawsuits and civil litigations blamed hedge funds and investment advisors (PIPE investors) for shorting borrowers’ stocks several years ago.
PIPE (private investment in public equity) deals go something like this: a distressed or thinly traded company in search for some quick cash will typically issue unregistered equity-linked securities (notes that charge interest, warrants, and options) to a group of investors (hedge funds and institutional investors) at a discount to the price of the issuer’s common stock at the time the deal is done. The issuer commits to registering the securities with the SEC so they can be resold to the public, typically within 90-120 days. In 2000 PIPE deals received a lot of attention from the public when so-called "death spiral" structured PIPEs had caused some companies to lose around 97% of their value.
Fenews.com described a typical death spiral as when a company issues convertible preferred stock or convertible debentures that convert into common stock; however, instead of being fixed, the conversion price changes based on how the issuer’s common stock performs after the deal is closed or over some predetermined period in the future. If the price of the common stock falls within that period of time, the conversion price drops according to a set formula, enabling the investor to get more stock for the same amount of principal. Of course, hedge funds love this arrangement for it gives them incentives to pound the price of the common stock down after the deal closes so they can rake in more stock.
Today, more common types of PIPEs include fixed conversion prices, which discourages short selling and mitigates investors from pounding stock valuations. However, death spiral PIPEs remain in the financial system.
Questions of short selling came up in 2003 when Sedona Corp. sued Rhino Advisors for supposedly manipulating the company’s stock (the case is ongoing). Rhino lined up investors into Sedona’s PIPE issuance in 2000. Ladenburg Thalmann, a NYC investment bank, gave Sedona a $3 million PIPE, which was a death spiral type where the more the stock went down, the more shares the bondholders were entitled to upon converting. In a Feb. 12 Forbes article, the publication questioned if Ladenburg did any short sales of the company’s stock before converting. In Feb. 2003 the SEC charged Rhino with shorting the stock by running them through a series of broker-dealers on behalf of Ladenburg – who contractually agreed with Sedona not to short the stock. Rhino settled out of court.
Certain forms of short-selling also present another problem, "empty voting." The Wall Street Journal reported that empty voting is very lucrative for hedge funds and brokerage firms. The opportunity arises when brokerage firms or institutional fund managers lend the shares they manage to hedge funds or other firms, for a fee that can rise with how difficult the shares are to get. Hedge funds sell the borrowed shares hoping to replace the borrowed stock with replacement shares purchased at a much lower price (PIPE transaction). They can also use the votes of the borrowed shares to vote on plans that would lower the company’s stock value thereby profiting off of short selling and PIPE investments. It should be noted that voting laws are dictated by state law. Under Delaware law voting rights belong to whoever holds the stock on a date the company chooses in advance of its stockholder meetings.
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