Gryphon Partners, a Dallas hedge fund, is weighing a settlement with securities regulators over allegations the $265 million money manager engaged in manipulative trading in shares of small-cap companies doing private placements of stock.

Within the past month, Gryphon sent a letter to investors in its flagship Gryphon Master Fund informing them the fund's managers are considering negotiating a settlement with the

Securities and Exchange Commission

to put the allegations behind them, according to people familiar with the letter.

The allegations of manipulative trading against Gryphon stem from an ongoing SEC inquiry into improper short-selling by hedge funds that invest in so-called PIPEs, or private investments in public equity. The allegations facing Gryphon were

first reported by

last November.

The investigation into the $20 billion-a-year PIPEs market has focused on allegations of improper short-selling by hedge funds trying to profit from the usual decline in a company's stock after a PIPE deal is completed. Shares of companies doing PIPEs typically decline in anticipation of a flood of discounted stock coming into the market.

To some degree, every PIPE deal is a bit of a Faustian bargain for a cash-strapped company. In selling discounted stock, or a bond that converts into discounted shares, a small-cap company is often betting that a near-term hit to its stock price is justified by the cash it raises.

In the letter, Gryphon insists it has done nothing wrong and is prepared to fight the SEC if it can't come to an agreement, sources say. But the hedge fund, led by Edwin "Bucky" Lyon III, believes it's in the best of interest of investors to resolve the matter.

Investors in the Gryphon Master Fund also may be asked to approve the use of the fund's assets in an eventual settlement. Investors in Gryphon's Special Situations Fund would not contribute to any settlement regulators. There are no allegations of wrongdoing involving the Special Situations Fund.

Officials with Gryphon, which is not affiliated with the San Francisco-based private equity firm Gryphon Investors, did not return telephone calls. The hedge fund's attorney, Benjamin Rosenberg, declined to comment.

Up until the past few months, Gryphon had been one of the more active investors in the PIPEs market. Since 1999, the first year Gryphon began investing in PIPEs, it has sunk a total of $190 million into these private stock deals, according to PlacementTracker, a research firm. Last year, for instance, Gryphon invested in 29 transactions, making it the 19th most active PIPE investor.

This year, however, Gryphon has invested in only six deals, including PIPEs sold by

Pacific Ethanol

(PEIX) - Get Report


Elite Pharmaceuticals

( ELI). There's no indication that any of these recent deals are the subject of the current investigation. But people familiar with the PIPEs market say the SEC inquiry likely has caused Gryphon to become more restrained in its investment activity.

Gryphon's decision to negotiate a deal comes at a time when the SEC has announced significant settlements with other hedge funds that allegedly manipulated shares of companies doing PIPE transactions.

In March, Jeffrey Thorp paid a $16 million fine to the SEC to settle allegations his Langley Partners hedge fund complex carried out an illegal short-selling scheme involving 23 separate PIPE deals from 2000 to 2002. Last month, Deephaven Capital Management, the $3 billion hedge fund run by

Knight Capital


, paid a $5.7 million fine to settle allegations that on at least 19 occasions it improperly shorted shares of companies doing PIPE deals.

has previously reported that at least three other hedge funds, Alexandra Investment Management, Cornell Capital Partners and HBK Investments, are being investigated by regulators as part of the PIPEs inquiry.

Some hedge funds have argued the SEC crackdown on the PIPEs market is misguided. They note that, until recently, it wasn't widely understood that it was wrong to short shares of a company while the transaction is still a secret. But this argument doesn't seem to be holding much weight with the regulators.

"When you get material that says it's confidential, it's hard to say, 'I didn't know,' " says Robert Mazzeo, a partner with Mazzeo Song, which represents hedge funds, many of which invest in PIPEs. "If you are in the market all the time, you pretty much know the game.''

The investigation, meanwhile, also is looking at the role of Wall Street brokerages that arrange the deals, and whether any of those firms have engaged in improper insider trading.

Last year,

Friedman Billings Ramsey


proposed paying a $7.5 million penalty to regulators to settle allegations arising from its role as the placement agent for a 2001 PIPE deal. The SEC and the NASD have yet to decide to accept firm's settlement offer. The investigation of FBR led to the resignation of the firm's co-founder Emanuel Friedman, who himself is facing possible regulatory action.

In December, a former

SG Cowen

managing director was sentenced to two months in a federal prison after he pleaded guilty on an insider-trading charge. Prosecutors charged Guillaume Pollet with illegally shorting shares of three companies that were doing PIPE deals, each of which had been arranged and managed by Cowen's investment bankers.

Cowen, which is being spun off by

Societe Generale

in an upcoming IPO, has disclosed that it too could face regulatory action over Pollet's conduct.