By Sey-Hyo Lee, Kevin Smith and Ruslan Koretski

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). 

Advantages 

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. 

Disadvantages 

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.