Another federal court has dismissed SEC claims that that covering pre-effective short sales with PIPE shares violates Section 5 of the Securities Act of 1933, as amended (the "Act"). On January 23, Judge Eduardo Robreno of the United States District Court for the Eastern District of Pennsylvania dismissed the SEC's Section 5 claims against a PIPE investor in SEC v. Berlacher (CA 07-3800-ER). The case is noteworthy because the SEC had tried to introduce new arguments in an effort to change the result of the recent Gryphon Partners and Mangan cases. Berlacher involved the same familiar fact pattern as the earlier cases: an investor purchased shares in a PIPE transaction and simultaneously sold short an equivalent number of shares in the open market. Those short sales were ultimately covered with the shares purchased in the PIPE.
As in the earlier cases, in Berlacher the SEC alleged violations of both Section 5 of the Act and Section 10(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and Rule 10b-5 promulgated thereunder. The SEC, in a supplemental filing, attempted to introduce several novel arguments in an attempt to salvage the positions rejected by the courts in the Mangan and Gryphon Partners cases. The SEC argued that the term "sales" as defined under the Act should be interpreted broadly to encompass the shorting of the shares and the subsequent covering with the PIPE shares. The SEC also argued that tax cases holding that short sales constituted the disposition of an underlying long position should persuade the Court that such shorting involved the sale of the PIPE shares for purposes of Section 5, even though other shares were used to settle the short sales. In addition, the SEC argued that the defendants could not rely on the ordinary trading exemption contained in Section 4(1) of the Act for the short sale because their conduct made them "underwriters" with respect to the PIPE shares. The SEC attempted to support this position by arguing that the short sales and subsequent covering transactions were part of an overall attempt to illegally distribute the PIPE shares.
Finding the SEC's arguments unpersuasive, the Court dismissed the SEC's Section 5 claims and ordered the SEC to clarify certain aspects of its Exchange Act claims. Judge Robreno apparently did not issue a written opinion to accompany his order.
While the Mangan and Gryphon Partners cases have been roundly criticized by a number of well respected commentators, it is becoming increasingly difficult to ignore the weight of the case law. Because all of these cases are proceeding on the various Exchange Act claims, the SEC will have the right to appeal the dismissal of the Section 5 claims once the remaining claims have been decided. So far, the SEC hasn't said definitively whether it plans to appeal these decisions. Investors who want to engage in this type of short selling and have the stomach for covering pre-effective short sales with PIPE shares now have additional precedent to support their actions. However, even after three straight losses, it is hard to believe that the SEC will give up on this issue and the more prudent course may be to wait and see what the SEC ultimately does in response to these adverse decisions.