Investment banker Emanuel Friedman, a co-founder and former chairman and CEO of Friedman Billings Ramsey ( FBR), is receiving a harsh penalty from securities regulators for his role in an improper insider trading scheme in a five-year-old private placement.

The Securities and Exchange Commission jointly imposed a $1.2 million fine as part of settlement with Friedman, who resigned from the investment firm more than a year ago after it became clear regulators intended to bring an enforcement action against him and the firm he helped start. Friedman Billings is paying a $7.7 million penalty for its role in the improper trading affair.

Friedman, who recently launched a new unregistered investment firm called EJF Capital, is barred from serving in a supervisory role for a brokerage firm for the next two years.

The settlement with Friedman stems from a long-running investigation into allegations of improper short-selling by hedge funds and other traders in a so-called PIPE, or private investment in public equity, that raised $12 million for Compudyne ( CDCY), a small Maryland security firm. The Compudyne investigation arises from a two-year-old probe into improper trading in the $22 billion-a-year market for PIPEs, which is a popular financing method for cash-strapped small companies.

Friedman Billings arranged the PIPE deal for Compudyne and lined up hedge funds to buy the sharply discounted shares that the company was selling in order to raise capital. As the investment banker on the deal, Friedman Billings earned a fee in excess of $1.76 million dollars.

But regulators allege that Friedman and the investment firm violated its obligations to Compudyne by failing to adequately police the trading of the hedge funds investing in the deal -- some of whom improperly profited by shorting shares of the company ahead of the transaction. Worse, the investment firm also improperly shorted shares of its banking client, generating a $343,773 trading profit in the process.

There's nothing inherently wrong with shorting -- betting a stock will fall in price. But regulators say it's wrong for hedge funds and others to short a stock in advance of a PIPE deal using the knowledge that a company is about to sell shares at a discount to the prevailing market price. It's also wrong to use the shares obtained in a PIPE deal to close out those pre-existing short bets.

"Individuals who exercise control over regulated entities will be held responsible when they fail to ensure that those entities comply with their obligations under the federal securities laws,'' says Dan Hawke, the administrator of the SEC's Philadelphia office. "The individuals charged in today's complaint failed to do so and are being held accountable for their failures to ensure FBR's compliance with those obligations."

In settling with Friedman, the regulators also announced settlements with two other former Friedman Billings executives, including the firm's former chief compliance officer Nicholas Nichols and the firm's former top trader Scott Dreyer. A year ago, the Virginia-based investment firm offered to settle with the regulators for about $7.5 million and already has set aside money to cover the cost. Last month, Friedman Billings agreed to pay Compudyne $4.5 million to head off a possible lawsuit by its former client.

"This settlement furthers NASD's efforts to prevent and deter abuses in the rapidly growing market for PIPEs," said Cameron Funkhouser, the NASD's senior vice president for market regulation.

The PIPEs investigation is beginning to lead to a number of actions against hedge funds and the brokers that arrange these deals. Last week, the SEC filed insider trading charges against Gryphon Partners, a $265 million hedge fund and large PIPE investor. Earlier this year, Knight Capital's ( NITE) Deephaven Partners settled with regulators over its improper trading in the PIPE market. A former Cowen executive pleaded guilty last year to insider trading in a PIPE deal handled by the firm and was sentenced to two months in jail.

TheStreet.com previously has reported that regulators are considering bringing an enforcement action against HBK Investments, a $7 billion Dallas-based hedge fund that is a frequent PIPE investor.

The Compudyne PIPE deal has been a particularly fruitful one for regulators to mine.

This fall a federal grand jury in New York indicted former hedge fund manager Hilary Shane for her alleged illegal trading in shares of Compudyne. Shane was indicted some 16 months after she reached a $1.4 million civil settlement with the SEC and NASD. Shane and her former hedge fund were one of the largest investors in the Compudyne deal.

TheStreet.com has reported that the grand jury is looking at possibly bringing criminal insider trading charges against other investors in that deal.

Last December, John Mangan, a former FBR broker, was charged by the NASD with improper trading in shares of Compudyne on behalf of a hedge fund he ran. In settling with regulators, Mangan paid a $125,000 fine and accepted a permanent ban from working in the brokerage business. Mangan's lawyer declined to comment on the grand jury investigation some 16 months ago.

Regulators say the investigation of the Compudyne deal is continuing.

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