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PIPE Transactions: Part II - Legal Issues

In this second of a two-part series on PIPE transactions (private investment in public equity), Michael A Conza of Testa, Hurwitz & Thibeault takes a further look at some of the legal issues to be addressed when structuring such deals.

The tumultuous public markets of the past two years have resulted in increased interest by private investors in PIPE (private investment in public equity) transactions. PIPE investors purchase securities directly from a publicly traded company in a private placement transaction, typically at a discount to the market price of the company's common stock. Because the sale of the securities is not pre-registered with the SEC, the securities are “restricted” and cannot be immediately resold by the investors into the public markets. Accordingly, the company will agree as part of the PIPE deal promptly to register the restricted securities with the SEC. Thus, the PIPE transaction can offer the company the speed and predictability of a private placement, while providing investors with a nearly-liquid security at a discount from the current trading price.

Careful attention must be given to multiple legal issues that arise during the course of PIPE transactions. The compressed time frame of these financings leaves little margin for error or uncertainty. This article examines some of the key legal issues arising out of these transactions.

Valid Private Placement
The initial sale of securities by the company in a PIPE transaction must be completed as a valid private placement under federal and state securities laws. PIPEs are typically structured to comply with the exemption from registration contained in Section 4(2) of the Securities Act and/or the SEC's Regulation D safe harbor. The availability of these exemptions will depend upon the sophistication and financial status of the offerees and purchasers, the extent to which the offerees and purchasers have access to information about the company, the number of persons to whom offers are made, the number of purchasers (though neither the number of offerees nor purchasers is determinative) and the purchasers' intention about maintaining their investment in the company. Investors in a PIPE transaction typically will be required to represent to the company that they are “accredited investors” as defined in Regulation D. In addition, the offering must be conducted so as to avoid general solicitation or advertisement. Accordingly, the manner in which the company and any placement agent identify potential investors must also be considered.

Integration With a Public Offering
The SEC's “integration doctrine” is designed to prevent companies from improperly avoiding registration by dividing what may be considered, in substance, a single securities offering into multiple offerings. The SEC will examine multiple securities offerings of a company to see whether they should be treated as a single offering for the purpose of determining if the registration requirements of the Securities Act have been met, or if a valid exemption from registration exists. If a private and public offering are integrated, the general solicitation undertaken in the public offering, even if abandoned, may destroy the exemption for the private placement, resulting in a violation of the securities laws.

Accordingly, in order to avoid a “burst PIPE”, the company's past and proposed financing efforts should be reviewed to ensure that the private placement in the PIPE will not be “integrated” with:

• any public offerings completed or abandoned prior to the PIPE financing,
  
  
• the proposed subsequent registered resale of the securities issued in the PIPE, or
  
  
• any concurrent registered offering (including an active shelf registration statement).
  

Abandoned Public Offerings. Special integration considerations arise for companies commencing a PIPE transaction shortly after abandoning a public offering. The SEC's Rule 155 provides an integration safe harbor that enables a company to withdraw its public offering registration statement and commence private financing activities 30 days later. By contrast, before Rule 155, companies often were required to wait six months after withdrawal before commencing a private financing.

Subsequent Registration. The SEC has determined that a private placement of securities will not be integrated with the subsequent registered resale of those securities if the private placement was “completed” prior to the filing of the registration statement. The SEC will consider a private placement completed in either of two situations:

• all of the purchasers have fully paid the purchase price for the securities in the private offering, or
  
  
• each purchaser is irrevocably obligated to purchase a set number of securities, the purchase price is fixed (i.e., not contingent on market price or a fluctuating ratio) and the transaction cannot be renegotiated.

So-called “pure” PIPE transactions are designed to comply with the second of these tests, but the complexity of legal issues involved with that standard has made this an unattractive alternative for many companies and most major investment banks.

Concurrent Public and Private Offerings. As a policy matter, the SEC has permitted concurrent registered and private offerings to be made under the conditions set forth in its Black Box and other related “no action” letters. A “Black Box PIPE” would be undertaken, for example, during a period when the company has on file an effective resale or shelf registration statement. In such situations, the SEC requires that the private offering be made only to:

• persons who are qualified institutional buyers (QIBs) as defined in Rule 144A(a) under the Securities Act, and/or
  
  
• no more than two or three large institutional accredited investors.

In addition, the PIPE must otherwise qualify as a valid private placement.

Shareholder Approval
Nasdaq's shareholder approval rules may apply to a PIPE financing and can provide a trap for the unwary — particularly with respect to “venture capital PIPES.” For example, Nasdaq–listed public companies are required to obtain shareholder approval prior to the issuance of PIPE securities if the amount of common stock issued (or ultimately issuable due to any conversion or re-set mechanism) exceeds 20% of the company's outstanding common stock, unless the stock is issued at a price that equals or exceeds both the book and market value of the stock (which often is not the case in a PIPE transaction).

Further, if officers or directors are purchasing shares in a transaction that is priced below fair market value, Nasdaq requires prior shareholder approval unless their portion of the offering does not exceed the lesser of 1% of the company's outstanding stock or 25,000 shares (in the aggregate for all participating officers and directors). If an affiliate (such as a private equity firm) of an officer or director is investing in the PIPE, the company must examine whether the officer or director has a direct or indirect interest in the shares. Nasdaq has informally indicated that if the shares held by the affiliated firm are attributed to the director or officer in the company's proxy statement (as is often the case with a director affiliated with a private equity fund stockholder), then that director or officer is deemed to have an interest in and a benefit from the affiliate's investment in the PIPE even if he or she disclaims beneficial ownership of the affiliate's shares.

Nasdaq, however, provides a limited exception to the shareholder approval requirement if the company can establish to Nasdaq's satisfaction that the delay associated with obtaining shareholder approval would seriously jeopardize the company's financial viability. The use of this exception must be specifically approved by the company's board of directors or audit committee and disclosed in a press release and notice to the company's stockholders at least ten days prior to any issuance of securities.

Regulation FD
The SEC's Regulation FD prohibits the selective disclosure of material non-public information by public companies. Under Regulation FD, a publicly traded company that intentionally discloses material non-public information must do so in a manner designed to effect broad public dissemination of the information. Inadvertent selective disclosures must be cured promptly by disclosing the information publicly. Although Regulation FD excludes communications made in connection with most registered securities offerings, statements made in connection with private placements — including PIPE transactions — are not excluded. Companies engaging in PIPE financings need either to obtain nondisclosure agreements from, or refrain from providing any material, non-public information to, prospective investors. As a practical matter, obtaining free-standing nondisclosure agreements from potential investors in a PIPE transaction is often difficult, and many placement agents do not even attempt to do so. A common practice is to obtain oral nondisclosure commitments from the potential investors, and to bolster that with a “shrink-wrap” nondisclosure statement on the company's PIPE offering materials and a confidentiality representation and covenant from the actual investors in the final purchase document.

Regulation M
The SEC's Regulation M governs the extent to which placement agents may purchase or induce others to purchase securities of a company while a “distribution” is taking place. Unless the company's common stock is “actively traded” as defined in Regulation M, the placement agent will be required to stay out of the public market during the PIPE transaction (one or five business days prior to pricing, depending upon the dollar amount of the company's trading volume and public float).

Research Reports
The federal securities laws place restrictions on the ability of the placement agent's analysts to issue research reports with respect to the company from the time the placement agent is invited to participate in the company's PIPE financing until firm orders for all available shares of the restricted PIPE securities have been received. It should be noted that these restrictions are less stringent for large capitalization companies.

Conclusion
While the public offering markets have slowed over the last two years, the need to raise capital has not. More and more companies are utilizing alternative financing techniques, such as PIPEs, in lieu of traditional public offerings to secure financing whenever an opportunity presents itself. Although PIPE transactions may once have been uncommon or viewed unfavorably in the marketplace, properly structured PIPE transactions sold to well-chosen, established investors are now widely accepted as rapid and legitimate financing vehicles for companies seeking to raise funds to support growth.

Copyright © 2002 Testa, Hurwitz & Thibeault, LLP. All Rights Reserved

Michael A Conza is a partner at Testa, Hurwitz and Thibeault, LLP.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP.  For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com