United States: PIPEs Clogged

PIPE offerings are a relatively fast way for public companies to raise capital in a private placement without the cost and delay of an underwritten public offering."PIPE" stands for "private investment in public equity."

While sometimes perceived as a last resort for distressed companies, PIPEs have nonetheless become a popular financing alternative for small and mid-sized companies that have limited access to the capital markets or large companies that simply want quicker execution.

However, recent interpretations by the Securities and Exchange Commission of its Rule 415, which is the SEC rule governing so-called "shelf registrations" used in PIPE offerings, has chilled the PIPE market. These interpretations, issued through a series of SEC comment letters sent to participants in PIPE offerings, essentially state that PIPEs are primary offerings of the issuer and that PIPE investors are underwriters under the securities laws, which translates to increased liability exposure.

This article will provide an overview of PIPE offerings — how they are structured and why issuers are using PIPE offerings to raise capital — and then discuss Rule 415 and how recent SEC interpretations are affecting PIPEs.

Overview of PIPEs

A PIPE transaction is a private placement of equity or equity-linked securities by a public company to a limited group of individual or institutional accredited investors that is quickly followed by the registration with the SEC of those securities for resale into the public markets. Thus, PIPEs combine the speed of a private placement with some of the liquidity of a registered public offering. Many PIPEs are placed with hedge funds. Companies can offer a variety of securities in a PIPE transaction, including common stock and warrants to purchase common stock, convertible preferred stock or debt, or any combination of these securities.

In a typical PIPE offering, a company sells to accredited investors unregistered shares of common stock at discount to the current market price (often between 5% and 10%, but sometimes much steeper).The discount typically reflects the lack of immediate liquidity and the terms of the security offered. (The more illiquid a security, the higher the discount.) Issuers will often "sweeten" a PIPE offering by also issuing warrants that allow investors to purchase additional shares at a price equal to or at a premium to the current market price.

As the sale of the securities to PIPE investors is not registered with the SEC, the securities are "restricted" under the federal securities laws, which means they cannot be immediately resold by the investors into the public markets without registration or an exemption from registration. As result, PIPE investors receive trailing (or follow-on) registration rights under a registration rights agreement entered into with the company. These registration rights require the company to file a resale registration statement promptly following the closing of the private placement and to use its best efforts to have the registration statement declared effective by the SEC so that it can be used by PIPE investors to resell the purchased securities freely into the market. The deadlines for the company to take these actions are generally 10 to 30 days for filing and 60 to 120 days for effectiveness, with penalties for failure to meet these deadlines typically including liquidated damages paid to the investors ( for example, 1% or 2% of the aggregate proceeds per month) to make them whole for the lack of liquidity. The company must keep the resale registration statement effective and up to date during the entire period when PIPE investors are reselling their securities (typically for two years).

When compared to a registered underwritten public offering, a typical PIPE transaction offers significant advantages. PIPEs are generally completed on a much faster timetable. A PIPE transaction can be closed within a few days or several weeks, depending on the manner in which the PIPE is marketed. In contrast, an underwritten public offering for a smaller company can take several months to close.

The timing and scope of due diligence review by the investors is much more limited because there is no underwriter liability or the related need to establish a due diligence defense associated with a public underwritten offering.

The SEC review of the registration statement and the one-to- two-month delay that may accompany it is avoided until after the sale of securities (and, importantly, after the issuer has received the proceeds from the sale).

The cost of a PIPE transaction is significantly lower than a public offering. Documentation necessary for a PIPE transaction has become fairly standardized, and disclosure documents typically consist of existing public information already on file with the SEC. The faster timetable and limited due diligence also contribute to lower transaction costs. Placement agent’s fees are also typically lower than underwriting fees in a public offering.

PIPE offerings do not involve extensive road shows, which are typical of registered underwritten offerings and can divert senior management’s attention for significant periods of time.

Public disclosure of the PIPE transaction need not be made until definitive purchase commitments are received from the investors. As result, the transaction is less subject to market price volatility than a public offering.

PIPEs can accommodate more flexible deal structures and smaller offerings.

However, PIPE transactions do have disadvantages.

The securities are often offered at a significant discount to the market price in order to compensate investors for a temporary lack of liquidity, and this often leads to a decline in the issuer’s stock price after the deal is announced.

PIPEs may have significant dilutive effects, depending on the size of the offering, the discount and, for convertible securities, the conversion rate formulas.

The issuer may need to keep the resale registration statement effective for up to two years.

There is a danger of giving up control in the company if offered shares are concentrated in the hands of a small group of investors.

There is a risk (as evidenced by SEC enforcement actions) that potential investors who are contacted about the PIPE transaction will trade the company’s securities based on the knowledge of the pending PIPE transaction before that information has been made available to the general public.

Some investors also engage in naked short selling in the issuer’s shares before the PIPE offering is publicly announced. These investors sell shares of the company short without borrowing publicly-traded shares to cover their short positions and instead rely on the securities being acquired in the PIPE transaction, which often results in downward pressure on the price of the company’s stock.

Rule 415

To provide investors in PIPE transactions with liquidity, issuers have relied on Rule 415 under the Securities Act, which allows issuers to register resales by investors in the privately-placed securities to the public at market prices. These resales by PIPE investors are referred to as "secondary offerings" under the securities laws because they are offered or sold by persons other than the issuer. Secondary offerings are distinguished from "primary offerings" which are offerings made directly by or on behalf of the issuer.

Secondary offerings in PIPEs can (and often are) registered on a short-form registration statement known as a "Form S-3" if the eligibility requirements to use this form are satisfied. Short-form registration statements are much easier to prepare because they permit an issuer to satisfy most disclosure requirements by simply incorporating past and future periodic reports filed with the SEC. In order to utilize Form S-3, the issuer must be a reporting company for at least one year and have timely filed all required SEC reports.

For secondary offerings, the principal additional eligibility requirement is that securities of the same class must be listed and registered on a national securities exchange (NYSE, AMEX or NASDAQ) or quoted on the automated quotation system of a national securities association. (Note: The OTC bulletin board and the "pink sheets" do not satisfy this requirement.) Importantly, secondary offerings do not need to satisfy the "public float" test — the aggregate market value of voting and non-voting securities held by non-affiliates must be $75 million or more — that primary offerings must satisfy in order to use Form S-3.This means that smaller companies with public floats less than $75 million that have been reporting with the SEC for at least a year can register a secondary offering in a PIPE on Form S-3, whereas they would not be able to use a Form S-3 for a primary offering. (OTC bulletin board and pink sheet companies generally rely on the secondary offering provision of Rule 415 to register the resales of restricted securities issued in a PIPE transaction on the long-form Form S-1 or Form SB-2 registration statements, which do not permit forward incorporation by reference.)

SEC Interpretation

The SEC has recently begun to express a revised interpretation of Rule 415 through its comment letter process (not through more formal rulemaking or interpretive processes) which has the potential severely to restrict the access of small and mid-cap companies to the PIPE market and also affect PIPE transactions for issuers of all sizes.

For many years, participants in the PIPE market have characterized the resales by PIPE investors as secondary offerings based on published SEC staff telephone interpretations. The SEC staff has listed several factors that are considered in determining whether an offering is a primary or secondary offering. These factors include how long selling shareholders hold the shares, the circumstances under which selling shareholders receive the shares, the relationship between the company and the selling shareholders, the amount of shares involved, and whether selling shareholders are in the business of underwriting securities or acting as a conduit for the company.

Prior to 2006, the SEC staff had not provided specific quantitative guidance — for example, on how big an offering can be before it starts to look more like a primary offering — or indicated how much weight each factor should be given in the analysis.

Since late spring, SEC staff have seemed unwilling to permit the shelf registration of PIPE resale transactions that would involve more than 30% of the "public float," or total number of shares in the company held by investors who are not affiliated with the company. The staff view is that such offerings are in fact primary offerings, not secondary offerings. Moreover, the SEC staff appears to be requiring issuers to identify the selling shareholders in the registration statement as underwriters in the primary offerings and to specify a fixed price at which the securities issued in the primary offerings will be sold in the market.

The potential consequences of the characterization of a PIPE resale offering as a primary offering rather than a secondary offering are extremely troubling to issuers and investors in PIPEs. They include inability to use Form S-3 unless the issuer is eligible to use Form S-3 for primary offerings (i.e., the issuer can meet the $75 million public float test).

Selling stockholders will be deemed to be underwriters in the offering and must be named as underwriters in the prospectus. As statutory underwriters, selling stockholders would be subject to "section 11" underwriter liability for the registration statement, which would invariably result in investors undertaking more extensive due diligence similar to that in an underwritten offering in order to take advantage of the underwriters’ due diligence defense. As statutory underwriters, selling stockholders would be ineligible to use Rule 144 (the SEC safe harbor rule that, if complied with, allows investors to resell restricted securities in the public market subject to time and volume limitations without being considered an underwriter) to resell any of the securities issued in the private placement transactions. This could result in PIPE investors requiring registration statements to be maintained by issuers for longer than the two-year holding period under Rule 144.

Although the SEC has not articulated in writing its new position on Rule 415 in the context of PIPEs, based on the issues raised by the SEC in the comment letter process and informal discussions with the SEC staff members, the SEC staff appears to be focusing on the following characteristics of PIPE transactions in determining whether a primary offering is involved.

One issue is the size of the resale offering being registered — offerings of shares representing more than 30% of the issuer’s public float would likely be considered a primary offering. For purposes of the 30% public float test, the numerator includes all fully-diluted securities held by the selling stockholder (including any shares issuable upon exercise of warrants or conversion of convertible securities, without regard to any "blocker" provisions), while the denominator would only include actual outstanding shares held by non-affiliates.

Another issue is indicia of control by the selling stockholders, including any board representation or other contractual provisions enabling control of the issuer; the more control, the more likely the SEC would view the resale offering as a primary offering.

Another issue is the extent to which selling stockholders have a view towards distribution of the securities; the sooner investors are able to resell their securities after the issuance in the PIPE transaction, the more likely the SEC would view the transaction as a primary offering. Although not specifically addressed by the SEC, lock-up agreements may be able to address this concern.

The SEC also appears to give weight to the following characteristics of PIPE transactions, which are indicative of investment intent of the investors, when deciding that an offering qualifies as a secondary offering: participation of individual investors as opposed to institutional investors (because institutions are more likely to engage in short sales and underwriter-like activities), smaller discounts to the market price, and a larger number of investors.

Impact on PIPE Market

A record $27.7 billion in PIPEs deals were closed through December 22, up 38% from the volume in 2005.However, the uncertainty and potential liability exposure created by the SEC’s new interpretations of Rule 415 and the lack of clarity and formal guidance are having a noticeable effect on the market. By recasting secondary offerings as primary offerings, the SEC is eliminating most of the advantages offered by PIPEs to investors and issuers. The impact is even greater for smaller companies where a PIPE offering may be one of the only sources of capital available.

As an alternative to registration of resale of securities in a secondary offering, some practitioners are advising their clients that invest in PIPE transactions to rely solely on Rule 144 for resales and to price the private placement of securities accordingly.

The SEC is expected to issue more definitive guidance that both issuers and investors can rely on when structuring PIPE transactions; this guidance may be available shortly. Until there is further clarity from the SEC on how to structure PIPEs as secondary offerings, issuers and investors are likely to remain skittish.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.