Looking Out for Desperation Finance in PIPEs Deals

When publicly held companies find themselves strapped for cash and unable to tap capital markets, they increasingly are turning to a type of financing that can spell big trouble for existing shareholders: private investment in public equity transactions.

This year the dollar value of so-called PIPE deals is on a pace to eclipse the totals tallied in each of the last three years. In fact, with 392 companies raising $5 billion, 2004 is shaping up as the second-best year ever for these transactions, according to information compiled by PlacementTracker.

PIPEs are popular with hedge funds because buyers usually get preferred stock or bonds that convert into shares at discounted prices. The deals often include sweeteners, such as warrants, that permit the investors to buy additional shares at prices well below what ordinary investors would pay on a public market. In return, the companies, many of which would have difficulty tapping the public market for financing, get badly needed cash.

But the deals have major downside for existing shareholders, who suffer immediate dilution when an outside investor receives new shares, particularly at a discount to the market price. More alarming, Securities and Exchange Commission sources say, these negotiated investments are drawing increasing scrutiny of late because of the potential they create for savvy investors to manipulate stocks.

Last year, for instance, Rhino Advisors paid a $1 million fine after the SEC charged the unregistered investment advisory firm with manipulating the stock of Sedona by shorting the tiny software company's shares following a $3 million PIPE deal. Regulators charged that Rhino shorted the stock on behalf of one of its clients, Swiss-based Amro International, which had purchased a $3 million convertible note from Sedona in a deal negotiated by Rhino.

The terms of the PIPE deal entitled Amro to more shares of Sedona stock if the company's share price fell significantly before the date the note was due to convert. But the PIPE also prohibited Amro from trying to hedge its interest by shorting Sedona's shares during the life of the note.