Shareholder litigation and short selling ahead of private equity placements

• Published date: 01 November 2023
• Author: Onur Bayar,Yini Liu,Juan Mao
• Date: 01 November 2023
• DOI: http://doi.org/10.1111/fire.12347

DOI: 10.1111/fire.12347

ORIGINAL ARTICLE

Shareholder litigation and short selling ahead of

private equity placements

Onur Bayar1Yini Liu2Juan Mao3

1University of Texasat San Antonio, San

Antonio, TX, USA

2University of WesternOntario, London, ON,

Canada

3University of Texasat San Antonio, San

Antonio, TX, USA

Correspondence

Yini Liu, University of WesternOntario,

London,ON N6A 3K7, Canada.

Email: yliu4287@uwo.ca

Abstract

We examine the impact of shareholder litigation on short

selling ahead of private investments in public equity (PIPEs).

We find that PIPE issuers that incurred securities class

action lawsuits prior to the PIPE are shorted more heavily

ahead of the PIPE issue. The case status at the PIPE date,

the severity of the lawsuit, and the timing of the private

placement after the litigation event also affect the extent

of short selling activity ahead of PIPEs. Consistent with

hedging incentives, the effects of prior shareholder litigation

on short selling are more pronounced in PIPEs where lead

investors are hedge funds and in traditional PIPEs.

KEYWORDS

law and finance, private investment in public equity (PIPE), securi-

ties class action litigation, short selling

JEL CLASSIFICATION

G14, G32, K41, K42

1INTRODUCTION

Our study focuses on short selling activity ahead of private investments in public equity (PIPEs) when there are prior

securities class action lawsuits. PIPEs have gained increasing importance in the U.S. as an equity or equity-linked

financing venue by publicly traded firms. The market for private investments in public equity (PIPEs) has exceeded

the traditional seasoned equity market in both transaction value and the number of deals. In 2021, 2819 closed

PIPE transactions in the U.S. raised a total dollar amount of $245.91 billion by issuers with a median closing market

Thisis an open access article under the terms of the Creative Commons Attribution- NonCommercial-NoDerivs License, which permits

use and distribution in any medium, provided the original work is properly cited, the use is non-commercial and no modifications or

adaptations are made.

© 2023 The Authors. The Financial Review published by WileyPeriodicals LLC on behalf of Eastern Finance Association.

Financial Review. 2023;58:833–858. wileyonlinelibrary.com/journal/fire 833

834 BAYARET AL.

capitalization of $69.78 million. In contrast, 495 seasoned equity offerings (SEOs) raised a total dollar amount of

$149.07 billion by issuers with a median closing marketcapitalization of $1.88 billion over the same period.1

In this paper, we investigate whether prior securities litigation affects outside investors’ hedging motivesahead

of PIPEs through short selling activity. Securities class action lawsuitscommonly include, but are not limited to, such

offenses as financial misrepresentation or misreporting, the release of misleading forward-looking statements, stock

price manipulation, insider trading, and violations related to mergers and acquisitions or sales of securities. Thus, one

potential implication of securities litigation is a greater risk of transacting with well-informed opportunistic insiders in

an information environment with increased uncertainty about the litigated firm’s prospects. Therefore, securities liti-

gation can negatively impact a firm’s access to the capital marketsby increasing its valuation uncertainty and thereby

raising its cost of capital.

Securities class actions occur before approximately 22.96% of all PIPE transactions in our sample of public firms

with non-missing data on stock prices and short interest.2Given the above considerations, it is intriguing that many

firms with prior securities litigation havenevertheless been able to revisit capital markets to issue new equity in PIPEs

even though their reputations took a major hit after they were sued by their shareholders in securities class action

lawsuits (see, e.g., Autore et al., 2014; Gande & Lewis, 2009). In this context,a natural question is how investors would

hedge their risks prior to such PIPE transactions in which there is increased uncertainty about the prospects of a PIPE

issuer with prior securities litigation. The hedging incentives of investors participating in the PIPE transaction of a

firm with an ongoing securities class action lawsuit should be stronger. In addition to the hedging benefits for PIPE

investors, short selling may also haveimportant price discovery benefits because short sellers are able to acquire and

process value-relevant information about issuing firms and make the equity marketmore efficient by trading on their

information advantage.3

The goal of this paper is to examine how short selling might facilitate the external financing of firms with prior

securities litigation by allowing investors to better hedge against increased risks and uncertainties of issuing firms

with ongoing securities class action lawsuits. Brophy et al. (2009) argue that PIPE investorstend to finance companies

that have pronounced information asymmetries and risky fundamentals. Investorssuch as hedge funds can offset the

issuer’s risk by short selling the underlying securities or by holding nontraditional securities. Investors of traditional

PIPEs can hedge their risk by shorting the underlying stocks, which helps them capture the PIPE discount while elimi-

nating their risk exposure.4The incentives to hedge should be greater for traditional PIPEs than for structured PIPEs

because structured PIPEs are already partially protected against price declines. Lim et al. (2021) suggest that PIPE

firms issue equity to relatively risk-tolerant investors such as hedge funds and private equity funds in offerings that

have higher expected returns and higher volatility.PIPE investors’ abnormal returns appear to reflect compensation

for providing capital to riskier and more constrained firms. Hillion and Vermaelen (2004) argue that structured PIPE

securities (floating-priced convertibles) might give their investorsthe incentive to manipulate the price downward to

receive a higher percentage of the firm upon conversion.One way to reduce the effective price temporarily is to short

sell the stocks aggressively.

The first research question we investigate is whether PIPE issuers that were sued in a pre-PIPE securities class

action lawsuit are shorted more heavily prior to the PIPE closing date. Weuse a sample of 366 securities-related class

action lawsuits that were filed before PIPE transactions with hand-collected information about lawsuit allegations.

We obtain a sample of PIPE issues from 2001 to 2018 and we partition the sample of PIPE issues into two groups. The

first group of PIPEs consists of those in which issuing firms were sued in securities class action lawsuits before the

1Thesesummary statistics about PIPEs and SEOs are obtained from PrivateRaise and SDC databases, respectively.

2This frequency of litigation actions on PIPE issuers listed on NYSE and NASDAQis much higher than the frequency of litigation actions in all public firms

(includingOTC firms) reported in the existing literature (Hanley & Hoberg, 2010; Krishnan et al., 2012; Autore et al. 2014), which is around 7%–10%.

3See, for example,Boehmer et al. (2008); Karpoff and Lou (2010); Berkman and McKenzie (2012); Engelberg et al. (2012); Boehmer and Wu (2013); Autore

etal. (2018); and Boehmer et al. (2020).

4TraditionalPIPEs are private placements where the securities are sold at a predetermined price and include common stock, fixed convertible preferred

stock,and fixed convertible debt. Structured PIPEs are equity-based, price-protected securities that include repricing rights, where the investor can convert

thePIPE security into a variable number of common stocks during the conversion period.