Thin end of the hedge
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The US hedge fund industry breathed a collective sigh of relief just two days into the New Year after the US Securities and Exchange Commission (SEC) failed in its latest attempt to outlaw certain hedging activity.
On 2 January 2008 the Honourable Sidney Stein, a US district court judge for the Southern District of New York, dismissed the SEC's allegations concerning violations of the registration and antifraud provisions of the federal securities laws in connection with 35 private investment in public equity (Pipe) transactions. The deals had all taken place between 2001 and 2004 involving Texas-based hedge fund Gryphon Partners and related entities.
The case was seen by the market as particularly significant in the context of the SEC's continuing efforts to regulate the US hedge fund industry. Stein is the second federal district court judge in recent months to reject the SEC's attempt to outlaw hedging activity in connection with Pipe deals.
In this case, according to the SEC's complaint, after investing in a Pipe, Gryphon allegedly hedged its investment by selling short stock in the Pipe prior to the registration statement being declared effective. The SEC further alleged that many of the short sales were "naked", meaning that Gryphon's broker had not borrowed shares to fulfil the short sales.
Once the SEC declared the Pipe registration statement effective, Gryphon allegedly used the newly registered Pipe shares to cover its previously executed short sales. The SEC claimed that course of conduct violated the registration provisions of Section 5 of the Securities Act of 1933.
The SEC maintained that using Pipe shares to cover pre-effective short sales constituted an impermissible distribution of the Pipe shares and the short sales should be deemed to be sales of the Pipe shares. In October 2007 a different federal court dismissed similar claims in SEC v Mangan (2007), but the Gryphon enforcement action had the added twist of fraud allegations in addition to the alleged non-fraud Section 5 registration violations.
The SEC increased the severity of the Section 5 charges by alleging that the covering of pre-effective short sales with Pipe shares also violated the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and related rules.
The SEC took this position based on certain representations allegedly made by Gryphon in agreements it had entered into with the Pipe issuers. These stated that Gryphon was purchasing the Pipe securities for its own account and without any present intention of distributing the securities.
That representation, the SEC argued, was fraudulent in light of Gryphon's covering of pre-effective short sales with Pipe securities after the registration statement went effective.
Judge Stein rejected the SEC's claims that the conduct violated either the registration provisions or the antifraud provisions. He stated: "Taking into account the authority presented by the SEC in support of its position, this court nevertheless finds implausible the proposition that a short sale constitutes a sale of the security that is eventually used to cover the short position.
The court therefore concludes that the Pipe shares used to cover defendants' short positions cannot be considered sold or offered for sale pursuant to Section 5 at the time defendants sold short the Pipe issuers' publicly traded securities. Accordingly, the SEC has not pled a plausible claim against [defendants] for violating Section 5, and that claim is hereby dismissed."
Judge Stein allowed the SEC's claims based on insider trading to go forward, noting that the SEC had stated a "plausible" claim that would be the subject of further litigation between the parties based on the particular facts and circumstances of the case.
Judge Stein's decision comes slightly more than two months after the very first court ruling on the SEC's Section 5 legal theory, which also rejected it. In late October 2007 the Honourable Graham Mullen, the US district court judge for the Western District of North Carolina, rejected the SEC's Section 5 claims against defendant John Mangan.
However, Judge Stein's decision in Gryphon goes further than Judge Mullen's. The facts, circumstances and legal theories in the Gryphon case were broader and more complex.
The SEC alleged 35 Pipes by Gryphon and only one by Mangan. The SEC alleged that Gryphon engaged in naked short selling through a Canadian broker, but made no such allegation against Mangan. And the SEC alleged that Gryphon engaged in "matched orders" and "wash sales" and that its conduct was fraudulent in contravention of the specific representations laid out in its deal documents, but did not make any such allegations against Mangan.
What now for the SEC?
Although two federal district courts have rejected the SEC's Section 5 theory, and Judge Stein has rejected the SEC's related fraud theory, the SEC has not indicated whether it will re-evaluate its enforcement efforts in this area. Indeed, the SEC may appeal the unfavourable district court decisions and the organisation continues to assert its theories in other active cases in other jurisdictions.
The future of the SEC's legal theories in this area remains uncertain and will only be clarified in the coming months by appellate review in Mangan or Gryphon, further evaluation of the theories by other federal district courts in other SEC actions, or new enforcement matters brought by the SEC.
Nicolas Morgan and Perrie Weiner are partners at DLA Piper