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JUNK EQUITY DEALS CAN HARM STOCK
While a "floorless convertible" offering can help a struggling company, the floating conversion feature is potentially ruinous.
By Robert C. Friese and Jahan P. Raissi
as published in The National Law Journal, February 15, 1999
In the 1980s, troubled companies often turned to junk bonds as a source of last-resort financing. More recently, small, struggling public companies that cannot raise capital through traditional means have turned to a relatively new type of security, which, depending on one's point of view, has been called a "floorless convertible," "toxic convertible," "death spiral convertible" or simply "junk equity." Although these securities can be a boon to a struggling company, they can also be the final nail in its coffin if not structured properly.
Abuses of these securities are causing substantial losses to the investing public and great harm to many companies that rely on them for financing.
Although the possible permutations are many, floorless convertibles typically take the form of privately place preferred equity or debentures that are convertible to common stock after a fixed period of time. The conversion price is generally discounted 15% to 30% from the market price of the common stock at the time of conversion.
What distinguishes these securities is that the conversion ratio is tied to, and varies with, the market price of the underlying common stock --- hence the name "floorless" convertibles. The lower the market price of the common stock at conversion, the greater the number of common shares the company must issue to holders of the floorless convertibles.
Like many other seemingly good ideas that often don't work in practice, the concept of floorless convertibles is theoretically sound. Given honest, nonmanipulative market activity in the underlying common stock, when properly structured the capital raised in an offering of floorless convertibles can allow a struggling company to realize greater shareholder value.
Unfortunately, the history of these offerings has shown that the results are often ruinous for companies and their shareholders. This has become a serious problem since this type of security has grown to an annual billion-dollar-plus cottage industry for certain of its promoters.
The source of most of the recent problems with floorless convertibles has been the floating conversion feature. If the market price of an issuer's common stock declines, the floating conversion feature can result in an unexpectedly large number of common shares being issued at conversion.
The release of large quantities of common stock into the market can significantly depress the market price of the common stock and can necessitate an even greater issuance of common stock in subsequent conversions. This phenomenon can create a downward spiral in the market price of the common stock as greater numbers of shares are sold into the public market.
Moreover, the issuance of large blocks of new common stock severely dilutes existing shareholders. The floating conversion feature also provides the unscrupulous with an incentive to depress the market price of the company's common stock.
Even for legitimate investors, there is an incentive to try to lock in profit by selling the issuer's common stock short, covering with shares obtained in the conversion. Often, the cumulative effect of market manipulation, short-selling and the food of common stock onto the market has been to put a company and its stock into the "death spiral."
High-Tech Targets
Some companies in the high-technology sector recently have been using floorless convertibles. Shares of these companies often are thinly traded, making them especially susceptible to price drops when the converted shares reach the market or when they are faced with sustained short sales.
Though floorless convertibles can be used by seasoned companies in turnaround situations as well as by new companies, the common denominator in such offerings is the issuer's lack of a source of conventional financing. Without the ability to tap into traditional debt or equity funding, issuers resort to floorless convertible offerings and often have little bargaining strength to avoid or blunt some of their more dangerous features.
The appeal of these instruments to their purchasers is easy to understand. The floating conversion ration and discount to market provide protection against a drop in the price of the common stock and usually all by assure the holders a profit.
To try to lock in a profit, the holders of the floorless convertibles sometimes will sell the issuer's common stock short and, thereafter, will cover with the converted common stock.
Alternatively, a holder may simply convert in to common stock at a discount to market and sell the stock to public investors, often pursuant to a registration statement on Form S-3, at a guaranteed profit. An emerging body of largely professional investors actively solicits companies for this type of private placement.
The Threat of Manipulation
Floorless convertibles pose serious dangers for issuers, even when the securities are held by legitimate investors. In the wrong hands, floorless convertibles are a stock manipulator's dream. If the holder of a floorless convertible sells the common stock of the issuer short, the market price of the security is driven lower and, at conversion, it will provide the holder with more common shares. The holder can use the shares received in the conversion to cover its short position and still may have shares to sell in the open market.
Sales in the open market may further depress the market price and increase the number of common shares received in subsequent conversions. The further the market price of the common stock declines, or can be driven down, the greater the profit.
In some cases, the manipulation of the issuer's common stock is overt. Traders have observed large buy orders immediately countered with several sell orders at prices below the immediately preceding buy order.
"Marking the close" in which sell orders are place at the close of the market to create a downtick and a bearish impression is one technique that has been used. Another technique involves massive short sales in situations in which almost no shares are available for borrowing, suggesting manipulative "naked" short selling.
In some of the most extreme instances, share prices of companies issuing such convertibles have been driven down by more than 90% for brief periods. On the heels of these price collapses, companies are presented with notices of conversion.
As the market price of the issuer's stock collapses, existing shareholders are hit with the one-two punch of a downward spiraling stock price and large-scale dilution of their holdings. Issuing companies sometimes face the delisting of their shares, permanently damaged capital structures and an inability to raise additional financing.
This turn of events can occur even in the absence of overt market manipulation. This flows from the holder's ability to lock in a profit by selling the issuer's common stock short and covering the position with shares obtained in the conversion.
In addition, professional short-sellers have caught on to the fact that the price of shares of companies that resort to floorless convertible financing will usually fall, and they seek out such companies as short-selling opportunities. Holders of floorless convertibles and market makers or others willing to short the stock sometimes enter into stock-loan arrangements, allowing the prospective short-sellers to borrow the stock needed for short sales.
Theoretical Limit
The shorting of shares is not illegal, but when done with manipulative intent or by brokerage firms or individuals without the ability to deliver the underlying common shares, shorting can become illegal and manipulative. The theoretical limit on such manipulation should be the "borrowability" of the issuer's shares, which is often nonexistent in thinly traded stocks, even from brokerage firms with large "short boxes."
Yet the fact that there may be no shares available to borrow does not seem to have limited the sort of shorting activity that has driven down the shares of many companies relying on this financing vehicle. This raises obvious questions of manipulation and enforcement of what are primarily self-regulatory organization (SRO) rules limiting most naked short-selling.
Regulatory Agencies
Securities regulators are beginning to pay closer attention to these instruments. The concern of the National Association of Securities Dealers (NASD) has been reported in recent months. The responses under consideration by the NASD run from informational campaigns to rules limiting the dilution of existing shareholders.
On Jan. 21, the NASD issued an interpretive release explaining the application of existing NASD rules to an offering of floorless convertibles by Nasdaq-listed issuers. The NASD release identified six NASD rules and categories of rules that may be implicated in such an offering: the shareholder approval rules, the voting rights rules, the bid price requirement, the listing of additional shares rules, the change in control rules and the discretionary authority rules.
Perhaps the most significant of the interpretations concerns the shareholder approval rules. Under certain circumstances, these rules require shareholder approval before the issue of common stock, or securities convertible to common stock, equal to 20% or more of the common stock outstanding before the issuance.
The release explains that, in applying the shareholder-approval rules, the NASD staff will look to the maximum number of common shares that could potentially be issued to determine whether the 20% threshold has been met. Thus, regardless of what is likely or anticipated, if, theoretically, the floorless convertibles could be converted into an amount of common stock equal to or greater than 20% of the outstanding common stock at the time the convertibles are issued, shareholder approval will be required before the floorless convertibles can be issued.
Similarly, both the Division of Corporation Finance and the Division of Enforcement of the Securities and Exchange Commission have been watching the developments surrounding floorless convertibles. The Division of Enforcement is investigating a number of floorless convertible offerings and the subsequent conversions and activity in the underlying common stock, some of which involve potential manipulative activity by entities and individuals abroad.
Issuers' Concerns
From an issuer's point of view, the regulatory concerns connected with an offering of floorless convertibles center chiefly on the private placement of the convertibles, the registration and resale of the common stock after conversion and the disclosure obligations arising from the offerings.
For investors, increased regulatory scrutiny is raising concerns. Litigation by shareholders is also on the increase. Although this may seem to be a logical area for shareholder litigation against alleged stock manipulators, manipulation cases are hard to prove and, to date, have not brought the plaintiffs' securities bar into action in a meaningful way.
One theory included in some cases brought recently asserts liability for short-swing profits under § 16(b) of the Securities Exchange Act of 1934. A sometimes-overlooked consequence of the floating conversion feature is that, if the price of the common stock falls far enough and the number of shares received in a conversion balloons, the holder may unexpectedly become subject to the short-swing profit provisions of § 16 and the reporting requirement of § 13.
Several disputes have arisen between issuers and the holders of the convertible securities. Faced with the prospect of extreme dilution of existing shareholders or of making a substantial cash payment when such cash may be unavailable, some issuers have simply refused to convert the preferred shares or to bring effective the registration of the underlying common shares.
Although this may give rise to possible contract-based claims by the holders of the securities, the few courts that have dealt with the issue have not been consistent in their responses. The responses have been largely driven by the specific facts, but the alternatives seem to be to uphold and enforce the literal reading of the certificate of designation, or to deny mandatory injunctive relief to the holder of the convertibles (based on availability of the legal remedy of damages or ambiguity in contract language).
Litigation commenced by the holders of floorless convertibles to compel conversion has met with accusations from the issuing companies alleging manipulation and bad faith on the part of the holders. Some issuers also have filed suits alleging manipulation against holders of floorless convertibles to prevent conversion.
It is too early to tell whether the volume of litigation will grow or what judicially created rules will emerge from these cases. On the one hand, the holders of the securities have a fairly straightforward contract claim for conversion and registration of the common shares. On the other hand, an issuer that can demonstrate manipulative activity or other illegal activity on the part of the holders of these securities should fare well in halting or limiting a conversion or registration. The few cases that have surfaced to date have either settled or remain unresolved on the merits.
What Should Be Done?
With at least hundreds of these offerings taking place and apparently more than a billion dollars being raised annually it would seem that some regulatory or legislative restrictions are needed. The NASD's recent interpretive release is a step in the right direction, but it is too early to gauge what impact it may have. In the meantime, the harm that can be done invites aggressive enforcement of the anti-fraud and anti-manipulation provisions of the federal securities laws and SRO rules.
Given the evidentiary difficulties a manipulation case presents and the absence of a private right of action for aiding and abetting since the Central Bank case, and because some of the questionable conduct occurs through brokerage firms and other regulated entities, the most effective enforcement mechanisms probably rest with the SEC and SROs. To date, no enforcement actions have surfaced, and one of the market participants who profit from these securities has stepped forward to help limit the abuses connected with these offerings.
Issuers' Awareness
In the interim, the best precautions against the harmful aspects of floorless convertible securities lies in the awareness on the part of the issuers and their counsel of where the danger lie. In general, if these securities can be avoided, they should be.
If such an offering is the only alternative, issuers should use contractual restrictions to mitigate the potential hazards of these securities. For example, the floorless convertible holder's ability to sell short or to enter stock-loan arrangements should be carefully and tightly restricted and probably prohibited altogether, if possible.
In addition, negotiating a minimum holding period before the common shares may be registered and resold is useful, as is restricting the right to convert (or the number of shares that may be converted) if the stock price drops below a certain point. A floor on the number of shares obtainable in a conversion, or a manageable cash payout alternative to a stock conversion, may also be useful to limit the harm these instruments can cause.
Finally, issuers need to perform the due diligence necessary to ascertain what type of investors they are dealing with before issuing these securities, including pursuing references to their experience (and that of the issuers) in such prior investments.
Beyond contractual provisions, the issuer may sometimes have the ability to deny the right to convert or to defer registration of the underlying common shares. Although both alternatives present obvious litigation risks, the obligation of the issuer to disclose fully all material facts before bringing a registration statement effective may justify deferring conversion, registration or both, especially when manipulative activity appears to be having a substantial impact on the issuer's common stock and, perhaps, on the company's listing status and ability to survive.
The floorless convertible security may in some instances be the only way a company can continue in business, and under such circumstances it may protect existing shareholders from a substantial or total loss of their investments. Thus, as a financing tool, this instrument has potential value and utility to some companies and their shareholders.
When investors in floorless convertibles are essentially guaranteed a profit, however, it has usually meant that existing shareholders pay the price through massive dilution and a collapsed stock price.
Unless and until tighter rules are in place, the only recourse for companies in need of such financing will be to understand thoroughly what they are getting into and to negotiate contractual provisions sufficient to blunt some of the more harmful features of these securities.
This article is reprinted with permission from the February 15, 1999 edition of The National Law Journal. © 1999 NLP IP Company.
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Toxic Convertibles, Poisoned Financing
Stacy Mosher
The Deal
November 22, 2000
Shareholder backlash is building against "floating" or "floorless"
convertibles, a type of so-called vulture capital financing that benefits an
investment bank if a company's share price drops.
Public companies are increasingly resorting to lawsuits to nullify these
agreements when their implications become clear. And individual shareholders
are exploring their own legal options -- both against investment banks and
the executives who agree to the flawed financing -- to compensate them for
loss in shareholder value.
Shareholders are also putting pressure on the Securities and Exchange
Commission to require more stringent disclosures that could nullify the most
harmful effects of these instruments.
These financing instruments, often referred to as "toxic convertibles," work
as follows:
Preferred shares are issued to investment banks that can be converted later
into common stock at a discount to the prevailing market rate. Under the
terms of many floating convertible financing agreements, the conversion can
take place earlier and more shares can be converted if the company's share
price drops.
Toxic convertibles are more commonly sold by smaller and less prominent
investment banks, but larger institutions have also on occasion used them.
Companies entering into these arrangements often find that their share price
heads due south soon afterwards. The dilution resulting from conversion of
large quantities of shares puts downward pressure on the share price,
sometimes sending the stock into a death spiral.
Some companies claim the devaluation of their share price is caused by more
than just dilution, and they have taken the financing firms to court,
alleging market manipulation.
Two cases were settled in 1999 and early 2000, and another case is pending,
against the same investment firm, New York-based Promethean Investment Group
LLC, which has been charged (along with other firms) with conspiring to
drive share prices down through short-selling.
The first case, involving Intelect Communications Inc. of Richardson, Texas,
alleged that Promethean and the other small firms, Angelo, Gordon & Co. LP
and Citadel Investment Group LLC, pushed the price of Intelect stock down
from $1.88 Feb. 24, 1999, to 66 cents per share April 21. During that same
period, the short-interest position in Intelect stock shot up from less than
1.5 million shares to more than 3 million shares.
After Intelect announced a moratorium on conversions of preferred shares,
the price of the common stock rebounded to $1.97 within days -- evidence,
argued Intelect, that the price drop resulted from market manipulation by
the firms.
The case was settled unusually quickly -- a month after the complaint was
filed in June 1999. Under the terms of the settlement, Intelect issued a
portion of the common stock claimed by the investment firms and cancelled
the remainder of the preferred shares.
The investment firms also agreed to a prohibition on involvement in short
sales or other transactions through which they would benefit from a drop in
Intelect shares, as well as agreeing to restrictions on the quantity of
Intelect shares to be traded on any single day.
The second case was filed by Ariad Pharmaceuticals Inc. of Cambridge, Mass.,
at the end of October 1999 against Promethean and a related company, HFTP
Investment LLC. Ariad alleged that Promethean admitted to shorting 2.5
million shares of Ariad common stock -- more than 10 percent of the total
outstanding shares -- and that the short-selling drove the Ariad stock price
down from $1.81 June 2, 1999, to 56 cents by Oct. 11, 1999.
Ariad charged that if Promethean continued to manipulate Ariad's stock "like
a yo-yo," it stood to realize a 300 percent return on its investment within
one year.
The case was settled in January, shortly after Ariad submitted a request for
all trades carried out by the investment firms through a New York brokerage,
Cathay Financial LLC. In the settlement, Ariad agreed to convert 612
preferred shares into roughly 1.08 million shares of common stock, which
Promethean then agreed to trade in the public market to cover its short
position.
In the most recent case, Log On America Inc. of Providence, R.I., alleges
that Promethean, Citadel and Marshall Capital Management Inc., an affiliate
of Credit Suisse First Boston, shorted Log On stock and drove the price from
$17 per share in February down to $2.50 by Sept. 26. The price plunge made
the firms eligible to purchase approximately half of Log On's common stock.
Marshall allegedly informed Log On that all of the investing firms held
"massive" short positions in Log On stock.
Court filings also list 12 other public companies in which Promethean and
Citadel have allegedly engaged in similar market manipulation.
Promethean released a statement describing Log On's claims as "outrageous"
and "the product of either reckless speculation or ... deliberate malicious
intent."
As shareholders are becoming more aware of the shortcomings of floating
convertibles in relation to shareholder value, Promethean's string of
lawsuits has brought it under increasing investor scrutiny.
In late August, executives of Nashville-based Shop At Home Inc. were quoted
in The Tennessean saying that an increasing number of investors had
expressed misgivings over a recently announced preferred stock arrangement
with Promethean.
"In the case of Promethean and certain other companies, you can't see
anything good in these deals," says Aaron Brown, founder of New York-based
eRaider.com, a mutual fund set up to unite shareholders against stock fraud
and poor management. "There's no protection written in, and the terms are so
inequitable that you can hardly believe company management ever discussed
them or even read them before signing."
Brown has been using Internet bulletin boards to rally investor pressure
against toxic convertibles. "We've been accumulating the necessary data to
show that these arrangements almost never work," Brown said. "But there is a
definite gradation of quality. Agreements involving Shoreline Financial
Corp. in California are the best you can find, with the necessary safeguards
and limits built in. Then you get the big investment banks like PaineWebber
Inc., which are usually not the worst."
Brown believes there's not enough money at stake in most of these cases to
attract the contingency-based law firms that typically take on class
actions, and inquiries with some leading class-action law firms indicate
that, in fact, toxic convertibles have not yet appeared on their radars.
But some lawyers who have conducted lawsuits against investment banks such
as Promethean on behalf of public companies believe that in theory similar
lawsuits could be brought by ordinary shareholders. "There would be a lot of
technical hurdles, but if shareholders asked me to get involved, I'd look
into it," one attorney said.
ERaider has targeted a toxic convertible signed by Transmedia Asia Pacific
Inc. as a particularly egregious case. "It was a good business with good
potential, but once it signed the agreement it lost 90 percent of its market
cap," Brown said.
Transmedia presents an example of the difficulties faced by this kind of
shareholder activism. Brown said he originally had the support of
institutional shareholders, but many of them sold off their stock, and
others went off and negotiated their own side deals. Worst of all, "The
people who were scammed are blaming us for exposing it and driving the price
down further," he said.
Brown says eRaider has decided to fight toxic convertibles in general in
recognition of the difficulties of winning individual cases. The group has
submitted proposals to the SEC to improve disclosure of toxic convertibles.
An SEC spokesperson said at present floating convertibles do not need to be
disclosed until the point where the investor wants to convert the preferred
shares into common stock for resale. At that point, the full risks of the
investment, including possible dilution and decline in share price, has to
be disclosed in a prospectus. There is no requirement to outline these same
risks to existing shareholders at the time the agreement is signed.
The spokesperson declined to comment on the possibility of more stringent
disclosure requirements in the future, but added, "It's a priority for us to
look at ways to make investors more aware of risks in investing."
The National Association of Securities Dealers Inc. calls for disclosure and
shareholder approval for what it terms "Future Priced Securities," but
shareholder approval is not necessary if the agreement caps conversion of
the security at 20 percent of the common stock, or if a floor is placed on
the conversion price. The 20 percent cap is easily evaded if conversion is
made in stages, and if the floor of the conversion price is low enough,
shareholders can still suffer significant depreciation of their holdings.
At the same time, any prudent reader of the NASD rules can detect a strongly
cautionary note toward this type of financing: "[T]he issuance of Future
Priced Securities may be followed by a decline in the common stock price,
creating additional dilution to the existing holders of the common stock."
But Brown believes the NASD rules do little to protect shareholder interest.
"Threatening to delist the company makes things even worse for
shareholders," he said.
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