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The U.S. Securities and Exchange Commission’s latest crackdown on hedge fund activities that involve certain types of short sales has been stymied by three court rulings in the past four months. The cases center on PIPE (Private Investment in Public Equity) transactions, which are private sales of unregistered stock in public companies. In recent years, the SEC has alleged that hedge funds, or their managers, have used PIPE transactions to “hedge” short sales of those same companies � in effect, selling unregistered securities in violation of Section 5 of the Securities Act of 1933. But in recent rulings on summary judgment motions, federal judges in New York, North Carolina and Pennsylvania have balked at the SEC’s theory. “Obviously, it’s a pretty substantial repudiation against the SEC, who brought these cases and now has lost uniformly across the board,” said Chris Clark, co-head of the white-collar defense group at New York’s Dewey & LeBoeuf, who represents a defendant in one of the cases. In a nod to the SEC, however, the judges allowed the cases to move forward on additional claims of insider trading. A dozen suits The SEC has filed nearly a dozen lawsuits against hedge funds, or their managers, over PIPE transactions in short sales. In a PIPE transaction, an underwriter, or placement agent, makes restricted shares of a public company available at a discount to certain investors, such as hedge funds. The investors agree to purchase those shares at a later date when the SEC declares their resale registration statement effective. In the interim, the investors are not allowed to sell those shares to the public. Once PIPE offerings are effective, they tend to cause a decline in a company’s stock price because they dilute share ownership and indicate financial problems at the company. That’s why PIPE shares are used in short selling, according to the SEC. In short sales, investors borrow shares and sell them, hoping for a decline in the stock price. If the price goes down, investors purchase the stock back at a lower price, realizing a profit, and return the shares. But short sales present risks, which some funds hedge with PIPE shares, according to the SEC. “In a nutshell, the SEC’s theory is that you can’t use PIPE shares to cover pre-effective short sales,” said Nicolas Morgan, a partner in the Los Angeles office of DLA Piper who represents a defendant in the latest ruling. “They’re saying when you sold short, effectively you were selling PIPE shares.” The SEC has obtained numerous settlements in its cases, most notably a $15 million agreement in March 2006 with hedge fund Langley Partners and its managers. SEC spokesman John Heine declined to comment on the court rulings. Nothing illegal In the first ruling, the SEC has alleged that John F. Mangan Jr., a former hedge fund salesman, directed short sales of stock in a company called CompuDyne Corp. while anticipating that CompuDyne stock obtained through PIPE transactions would “cover” those sales. U.S. Securities & Exchange Commission v. Mangan, No. 3:06-cv-00531 (W.D.N.C.). The SEC also alleges that Mangan engaged in insider trading because he had a duty to CompuDyne and its shareholders to keep the PIPE transactions confidential. In his October ruling from the bench, U.S. District Judge Graham C. Mullen refuted the SEC’s claims “that because the PIPE in fact was not registered and because the PIPE shares were later in fact used, he in effect sold the PIPE. Well, maybe, but I don’t think he did anything illegal.” The judge refused to dismiss the insider trading claims, but found the defendant’s argument that the sales had little material effect on the company’s stock “rather compelling and persuasive.” The SEC “seems to ignore the fact that oftentimes these PIPEs don’t get registered, in which case whoever shorted it has to go out in the market and . . . figure out how to cover it some other way,” said George C. Covington, a partner in the Charlotte, N.C., office of Atlanta-based King & Spalding, who represents Mangan. ‘Don’t hold water’ The second ruling involved the managing partner of several hedge fund entities, Edwin Buchanan Lyon, accused by the SEC of profiting from short sales of more than 30 public companies hedged with PIPE shares. The SEC also said he engaged in insider trading in some transactions. U.S. Securities & Exchange Commission v. Lyon, No. 1:06-cv-14338 (S.D.N.Y.). On Jan. 2, U.S. District Judge Sidney H. Stein refused to dismiss the insider trading claims, but found the SEC’s PIPE allegations “unwarranted” because they consider the shares in the PIPE transactions to be sold at the time of the short sales they covered. Clark, who represents Lyon, agreed, noting that “all of these judges basically said these allegations don’t hold any water.” Although he declined to comment, the SEC’s Heine referred to a footnote in the agency’s own rule revisions, issued in December, that states: “The Commission has previously indicated that, in a short sale, the sale of securities occurs at the time the short position is established, rather than when shares are delivered to close out that short position, for purposes of Section 5 of the Securities Act.” In the third ruling, the SEC sued hedge fund owner Robert A. Berlacher for profiting from PIPE shares in at least 10 public companies used to cover short sales. The SEC also accused Berlacher of insider trading. Securities & Exchange Commission v. Berlacher, No. 2:07-cv-03800 (E.D. Pa.). On Jan. 23, U.S. District Judge Eduardo C. Robreno, in a bench ruling, relied on the Lyon case in his dismissal. The critical factor in the judge’s decision, said Morgan, who represents Berlacher, is “recognizing that the short sale is a different transaction than the later cover.” Robreno allowed the insider trading claims to remain in the case.

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