Securities regulators are suing Gryphon Partners, accusing the $265 million Dallas hedge fund of engaging in an "illegal trading scheme" in conjunction with three dozen small-cap private stock placements.

The securities fraud charges against Gryphon, led by Edwin "Bucky" Lyon IV, arise from a more than two-year-old investigation into allegations of manipulative trading in the $22 billion-a-year market for PIPEs, or private investments in public equity.

The Securities and Exchange Commission, in a civil lawsuit filed Tuesday in New York federal court, allege Gryphon and Lyon "realized more than $6.5 million in ill-gotten gains" from 2001 through 2004.

Regulators allege Gryphon illegally shorted shares of at least 35 companies that sold discounted stock in PIPEs, a type of financing favored by small-cap companies in desperate need of cash. The SEC contends Gryphon "employed a variety of deceptive trading techniques" and misappropriated inside information to carry out its scheme.

An attorney for Gryphon could not immediately be reached for comment.

A short sale is a market bet that stock will decline in price. It's common for shares of a company doing a PIPE to decline after a deal is announced as investors adjust to a flood of discounted stock hitting the market.

It's legal for investors in a PIPE deal to short a stock after the transaction is announced. But it's generally illegal to do so before the deal closes and is made public.

The SEC filed the civil suit after talks aimed at negotiating a settlement broke down. TheStreet.com previously reported that Gryphon told investors it was interested in settling with the SEC. But people familiar with the negotiations say the hedge fund balked at the amount of money the SEC was seeking.

Regulators were believed to be seeking a penalty of at least $16 million, which is similar to one paid earlier this year by Jeffrey Thorp and his Langley Capital hedge fund. Langley carried out what regulators called an illegal short-selling scheme tied to 23 separate PIPE deals from 2000 to 2002.

Gryphon, even as it was trying to negotiate a settlement, told its investors that it had done nothing wrong. But Lyon told investors this summer that settling with the SEC was in the best interests of the fund and investors.

In the negotiations with the SEC, Gryphon hired securities law guru John Coffee , a professor at Columbia University School of Law and an expert on insider trading, to lobby for its cause. TheStreet.com first reported a year ago that Gryphon was under investigation in the PIPEs probe.

"Bucky Lyon and Gryphon Partners made millions of dollars of illegal profits by employing a trading strategy whose success depended on telling lies to PIPE issuers," says Scott Friestad, an associate director in the SEC's enforcement division. "To address this misconduct, we're planning to pursue significant penalties and sanctions against the defendants."

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.

Some of the companies doing PIPE deals that Gryphon improperly shorted from 2001 to 2004, according to regulators, include HealthExtras ( HLEX), MGI Pharma ( MOGN), AuthentiDate ( ADAT) and Generex Biotech ( GNBT).

In the complaint, the SEC alleges Gryphon inappropriately began shorting shares of companies before a PIPE was announced. The hedge fund did this even though it was warned by a lawyer that doing so could be improper, regulators say.

Regulators say Gryphon also engaged in improper short-selling by using an unnamed Canadian broker to engage in an illegal trading practice called naked shorting.

Naked shorting is an improper trading strategy in which a hedge fund shorts a stock without first borrowing shares from a broker, as is required under federal securities laws.

In a traditional short sale, a bearish trader must first borrow shares from a broker and then sell them. The trader then hopes to pay off the loan at a later date with stock purchased at a lower price, pocketing the difference as profit.

The SEC, NASD and federal prosecutors are continuing to investigate other hedge funds and brokers for manipulative trading in the PIPEs market. TheStreet.com previously has reported that hedge fund giant HBK Investments, also based in Dallas, is being investigated over allegations of wrongful trading. Sources say Friedman Billings Ramsey ( FBR) is close to settling with regulators over allegations its proprietary hedge funds illegally shorted shares of a company for which it managed a PIPE.

"Fraud and insider trading by hedge funds are a high priority" for the SEC, says Robert Kaplan, an assistant director.