Yesterday, Judge Sidney Stein of the United Stated District Court for the Southern District of New York handed the SEC a significant defeat, ruling in Securities and Exchange Commission v. Lyon (“Gryphon Partners”) that a PIPE investor did not violate Section 5 of the Securities Act of 1933, as amended (the “Act”), by shorting shares purchased in the PIPE and then covering the short sales with the PIPE shares once a resale registration statement had been declared effective.
Taken together with the recent decision of the United States District Court for the Western District of North Carolina in Securities and Exchange Commission v. Mangan (“Mangan”), Judge Stein’s ruling yesterday potentially opens the floodgates for increased short selling of PIPE securities.
In Gryphon Partners, the SEC alleged that several related funds (“Gryphon”) violated Sections 5 and 17 of the Act and Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), by, among other things, engaging in short selling (both covered and naked sales) of common stock purchased in PIPE transactions prior to the registration of the PIPE shares and covering those sales with the shares purchased in the PIPE once those shares were registered.
Ruling on Gryphon’s motion to dismiss, Judge Stein held that the short selling and covering transactions did not violate Section 5 of the Act. However, Judge Stein refused to dismiss related claims that Gryphon’s short selling, which in certain cases was done prior to the public announcement of the PIPE, violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.
Consistent with prior staff interpretations discussed below, the SEC alleged that Gryphon violated Section 5 by (i) shorting the common stock of a PIPE issuer at a time when no PIPE resale registration statement was in effect and then (ii) “covering” the short position with PIPE shares after the effective date of the relevant registration statement. However, the Court held that securities used to close a short position are not sold or offered for sale at the time when the short sale is made. In reaching its conclusion, the Court examined the mechanics of a short sale and concluded that publicly traded shares, not the PIPE shares, were sold in the short sale and that no sale of PIPE shares took place until the covering transactions were executed. In the Court’s analysis, how the short seller subsequently chose to satisfy the corresponding deficit in its trading account did not alter the nature of that sale.
The Court also found that the SEC’s position did not advance the purposes of Section 5 of the Act because there was no allegation that buyers of publicly traded securities in the short sales lacked sufficient information with respect to the securities they purchased. The Court carefully examined authorities previously cited by the SEC as support for its position and held that those authorities did not compel a different result. It noted that a number of authorities cited by the SEC involved pre-existing schemes or conspiracies to engage in illegal activities of which short sales were only a part. The Court also dismissed several SEC staff interpretations contained in the Manual of Publicly Available Telephone Interpretations noting that, by their own terms, the interpretations were not rules, regulations or even approved statements of the SEC, and therefore were not entitled to any deference beyond their “power to persuade.” The Court found the staff interpretations were not persuasive because they were conclusory in nature and did not set forth any reasoning supporting the staff opinion.
The Court’s ruling comes six weeks after the Mangan decision, which was decided from the bench and was not accompanied by a written opinion. While Gryphon Partners reaches the same conclusion as Mangan, Gryphon Partners is likely to have a more far-reaching impact on the behavior of PIPE investors because of Judge Stein’s lengthy and carefully reasoned opinion. While we, among others, urged caution in the wake of the Mangan decision, which was widely circulated in the PIPEs community for its entertainment value, we believe that PIPE investors will be emboldened by yesterday’s ruling and will begin to actively short PIPE investments prior to the registration of the underlying shares. The effect of this increased short selling will likely be increased downward pressure on trading prices of PIPE issuers’ shares and an increased focus on contractual prohibitions on short selling by PIPE investors.
The SEC has not appealed Mangan and the Gryphon Partners ruling is too new to know how the SEC will respond. However, these decisions are likely to throw a monkey wrench into the SEC’s much publicized effort to use its examination powers to generate information for use in enforcement actions in the PIPEs space. It is possible, however, that in response to these decisions the SEC will take formal action to adopt rules codifying the staff position which, while perhaps not directly supported by Section 5 of the Act, appears to be consistent with the SEC’s obligation to maintain fair and orderly capital markets.