Great article on toxic convertibles
this is part two of a series. I posted the first one. I asked the writer if it was okay.
Toxic convertibles. Death spirals. It's getting hostile
July 8, 2001
uniontrib.com
DON BAUDER
Cigarettes can kill. So can PIPEs.
PIPEs is the acronym for private investments in public entities -- funding devices that struggling companies increasingly are turning to in a hostile emerging company environment.
When the PIPE is an issuance of convertible debentures or preferreds, it often leads to what is known as a death spiral -- a collapse of the stock allegedly caused by massive shorting.
What's particularly interesting is that the private entities buying the convertibles -- known as toxic convertibles -- tend to be located in offshore, secrecy-shrouded tax havens.
Some of the victim companies complain that the entities that bought the convertibles are responsible for the shorting, either themselves or through surreptitious surrogates.
Other victimized companies feel that short sellers (those betting a stock will go down) pounce on a company that has sold toxic convertibles. The shorts figure the shares will be converted quickly, leading to a larger supply of low-priced stock, and thus more opportunities to successfully short a stock that is normally thinly traded.
Since it is shaky companies that usually resort to toxic convertibles, the shorts feel they have cornered helpless prey.
According to Red Herring magazine, death spiral deals were taken by 220 companies last year, accounting for $2 billion of the $18 billion in PIPEs.
Overwhelmingly, the stocks of the companies issuing convertibles collapsed. However, it is invidious to pin all the blame on the toxic convertibles. After all, Nasdaq -- particularly the emerging companies -- imploded in 2000.
Earlier this year, Mobile PET in San Diego filed a suit claiming that enterprises buying its convertibles worked together to drive the stock down. In June, Mobile PET settled the suit and withdrew the allegations.
Now, San Diego's ailing GreyStone Digital Technology, which provides military software, complains that it is in the grip of a death spiral.
In May of last year, the company sold $5 million worth of convertible preferred stock to 13 investors -- mostly offshore in such havens as Liechtenstein, Switzerland, the Turks & Caicos Islands, Isle of Man and the Bahamas.
"It was a mistake," says founder and chief executive Richard A. Smith. "The stock went from $6 to 20 cents." The deal was set up through an agent, and the company didn't learn that the convertible buyers were offshore until right before closing.
GreyStone complained to the National Association of Securities Dealers about irregularities in short selling. Among other things, the amount of short selling did not seem to correlate with the numbers that were reported to domestic authorities, says Carolyn Harris, GreyStone's general counsel.
"We went through all the filing procedures; nobody told us about this stuff," Smith says. The NASD found that "people selling the stock were not delivering the stock in a timely way, or at all."
The NASD notified broker-dealers, but GreyStone "has not heard a word" from the self-regulating body, Smith says.
Harris says: "One of the things that bothers this company is: 'Where are the regulators when you need them?' The NASD knew there was underreporting of the short position."
The NASD refuses to confirm or deny any investigation into the matter.
The underreporting of short positions might have been a function of the shorters being offshore, Harris says, hastening to add that GreyStone has not accused the offshore buyers of its preferred with the shorting.
But, Harris says, "If I had known in May of 2000 what I know now, I would have lain down on the railroad tracks" to block the deal.
Buyers of toxic convertibles usually say they have no motivation to drive down a stock in which they have a stake.
But, Smith says: "There is obviously an incentive for whoever the preferred shareholders might be to see the stock go down, not up, so they can get more shares (upon conversion)."
"This volatile Nasdaq market casts an enormous shadow. If there is illegal shorting or manipulation, it's difficult to determine because of the size of that shadow."
Of course, GreyStone has very big operational problems: Recently it filed for an extension of the submission of its 10-K statement to the Securities and Exchange Commission, because it had been behind on payments to its auditor.
Last month, it was delisted from Nasdaq. Losses are escalating, and the auditor questions GreyStone's ability to survive.
This spring, the company said it was shelving its attempt to diversify into providing arcade games to casinos. One company agreed to buy $7 million of GreyStone's games, but then the potential customer's parent backed out.
"That was the left punch," Smith says. "The right punch was that as soon as that happened, the lender pulled its credit."
But GreyStone wants to use both its military and games technology in some kind of rescue combination. "We are in discussions about a spin-off or a split-off of the entertainment side," Smith says.
The company has ongoing discussions about being acquired or acquiring somebody else, but Smith can't discuss that.
Don Bauder's e-mail address is don.bauder@uniontrib.com. His phone number is (619) 293-1523.
Copyright 2001 Union-Tribune Publishing Co. |
