From Matt Levine today --
I suppose we have to talk about Sorrento and Scilex, so here goes. Sorry!
Sorrento Therapeutics Inc. is a biopharmaceutical company. It is publicly traded and was listed on the Nasdaq until it filed for bankruptcy in February. The bankruptcy was caused by developments in some complicated litigation: Sorrento had sold a drug to another company called NantPharma to commercialize, and NantPharma alleged that the drug was not close to regulatory approval and that it had been scammed. [2] On Dec. 2, 2022, an arbitrator awarded NantPharma $175 million and, while Sorrento kept fighting that award and has won a different arbitration against NantPharma, it did not have anything close to $175 million in cash. So it filed for bankruptcy.
Sorrento has a subsidiary called Scilex Holding Co. Scilex is also a public company, also listed on the Nasdaq. Sorrento is its biggest shareholder; it currently owns about 43% of Scilex’s common stock, and it also owns preferred shares that give it majority voting power. Scilex’s stock closed yesterday at $5.08 per share. There are about 149 million common shares outstanding, so Scilex is worth about $750 million, and Sorrento’s controlling stake is worth hundreds of millions of dollars.
Sorrento’s stake was much bigger not too long ago: When Scilex went public last November, Sorrento owned about 96% of its stock, and was locked up from selling it until at least this May. [3] But on Dec. 30, 2022, after losing that NantPharma arbitration, Sorrento announced that it would distribute 76 million Scilex shares — roughly half of its stake — to its shareholders. In January, Sorrento handed out about 0.14 shares of Scilex stock for each outstanding Sorrento share, as a special dividend. Basically Sorrento had one asset — Scilex — worth hundreds of millions of dollars, it was heading for bankruptcy itself, and before it filed for bankruptcy it handed out that asset to its shareholders.
That’s. That’s, uh, pretty weird? Ordinarily it is considered bad form for a company to dividend out its assets to its shareholders just before filing for bankruptcy: Those assets belong to the creditors now, not the shareholders. In fact NantPharma sued in California Superior Court to stop Sorrento from paying out the dividend, arguing “that STI was balance sheet insolvent and ‘lack[ed] adequate capital to sustain operations and pay creditors,’” but the judge was like “meh no seems fine” and let Sorrento go ahead. [4]
So then Sorrento filed for bankruptcy, saying that “given the valuable (but currently locked up and restricted (with exceptions and carveouts)) Scilex stock that [Sorrento] owns, the Debtors are hopeful that … they will be able to propose a plan of reorganization that pays off all creditors (including the Nant Companies) in full and reinstates equity.” Sorrento’s stock still trades over the counter, and it closed at $0.315 yesterday, for a market capitalization of about $170 million, suggesting that its investors have some confidence in that plan.
Also the bankruptcy court has some confidence in that plan, because it appointed an Official Committee of Sorrento Equity Securities Holders so that Sorrento’s shareholders would have some representation in the bankruptcy. Ordinarily a bankrupt company doesn’t have enough money to pay its creditors, it splits what’s left among the creditors, the shareholders get nothing and there is no need to consult them. Here, though, it is apparently plausible that Sorrento will be able to pay off its debts and continue as a company owned by its shareholders, so it still owes those shareholders some fiduciary duties, and there’s a committee to represent them. [5]
But Sorrento is in bankruptcy, and that dividend of Scilex stock, in bankruptcy, looks crazy. Sorrento took like half of its value and just handed it over to its shareholders shortly before filing for bankruptcy. If it turns out that Sorrento doesn’t have enough assets left to pay off all its creditors, it would be very bad that Sorrento’s shareholders got hundreds of millions of dollars of Scilex stock right before the bankruptcy.
In bankruptcy law, this is called a “ fraudulent transfer”: If a company (1) transfers any property within two years before bankruptcy, (2) “received less than a reasonably equivalent value in exchange” and (3) was insolvent or close to it at the time of the transfer, then a bankruptcy court can claw it back. If Sorrento was insolvent in January— after the arbitration award that pushed it into bankruptcy — then surely its creditors can claw back the Scilex stock that it handed out to its shareholders for free.
Normally it’s very hard to claw back publicly traded stock: It trades on the exchange, thousands of regular investors can buy it, and if A buys shares from B who bought them from C who bought them from D who bought them from E who got them in a dividend, it is hardly fair to claw back the shares from A, who after all paid fair value for them. It is hard to trace all the money among anonymous public shareholders trading on the stock exchange.
But there is an oddity with Scilex stock. The oddity is that the Sorrento shareholders who got Scilex stock as a dividend can’t sell it. Because Sorrento couldn’t sell it — its Scilex stake was locked up until May 2023 — it dividended the stock to its shareholders subject to that restriction. “The Dividend Stock you will receive on the Payment Date is subject to restrictions on transfer until May 11, 2023,” Sorrento told its shareholders at the time.
And then once Sorrento was in bankruptcy, Sorrento’s creditors asked the bankruptcy court to extend that transfer restriction, so that they could try to claw back the Scilex stock if necessary. The bankruptcy judge agreed, extending the restriction until September. [6]
The thing is, Scilex stock kept trading. Since Sorrento’s bankruptcy filing, Scilex’s average trading volume has been more than 5 million shares a day. Now, the small public float of Scilex’s stock that was publicly held before Sorrento’s January dividend — the equity committee says it’s about 3 million shares [7] — is freely tradeable. The 62 million shares held by Sorrento, and the 76 million shares that Sorrento dividended out to its shareholders, though, are not allowed to trade. Almost all — not all, but almost all — of Scilex’s stock is locked up; the tiny amount of stock that is freely tradable sure seems to trade a lot.
What does that mean? If your answer is “shadowy hedge funds are conspiring with big Wall Street banks to print millions of phantom shares in order to naked short them and drive down Scilex’s stock in order to tank Sorrento’s bankruptcy,” then I am very sorry to tell you that the official equity committee agrees with you. Here is a lawsuit that they filed in the bankruptcy case last month against several big brokerages including Merrill Lynch, Morgan Stanley and JPMorgan:
This action concerns the pervasive and abusive “naked” short-selling – i.e., taking a short position without correlating shares being located and borrowed by the short-seller – of the common stock of Scilex Holding Company (“Scilex”) in violation of SEC regulations and established industry practices. The Debtors, which own a majority of the Scilex stock, are victims of these illegal practices. This action, brought by the estate fiduciary appointed to represent the Debtors’ shareholders with the Debtors’ approval, seeks relief against the defendant brokerage firms that have allowed illegal naked shorting of Scilex stock. …
The certifications filed by the Defendants with this Court prove that there has been illegal naked shorting of the Scilex stock. To obtain a legal short position, the short-seller must “borrow” or “locate” freely tradeable stock in the subject stock before closing the short sale. However, the reports provided by Defendants indicate that the short interest in Scilex stock totals millions of shares more than the entire public float of approximately 3 million Scilex shares. The ineluctable conclusion is that these short positions resulted from illegal short-selling.
The next day the bankruptcy judge, David Jones of the Southern District of Texas, issued an order banning short sales of the dividend stock.
The brokerages replied to these claims saying, essentially, what are you even talking about:
The alleged stay violation claims against them lack any basis and rest on a misunderstanding of basic facts, the Movants’ continued perpetuation of which amounts to misrepresentation. In particular, Movants did not appear to understand when the Adversary Proceeding was initiated that the short positions in Scilex Dividend Stock were all positions (not sales) inherited from short positions in Sorrento at the time of the dividend, and thus were the result of Sorrento’s own corporate action distributing those shares in January 2023. None of the Defendants’ customers’ short positions in Scilex Dividend Stock are a result of short selling in those shares, as trading in such shares remains restricted pursuant to Court order.
That is: If you were short Sorrento stock in January (normal, legal, not-naked short), what that meant was:
You had borrowed Sorrento stock from someone, andYou owed them back their Sorrento stock, plus any dividend on that stock.So when Sorrento dividended out 76 million shares of Scilex stock, that created millions of shares of short positions in Scilex: Everyone who was (normally, legally) short Sorrento now owed their share lenders some Scilex shares as well. The short positions were not created by naked short selling of phantom shares in a nefarious Wall Street conspiracy: They were created by the mechanical effect of Sorrento’s own dividend.
Still there might be a real problem here. If you were short Sorrento stock in January, you were right — Sorrento filed for bankruptcy the next month, and the stock went from about $2.50 a year ago to about $1 in January to about $0.33 today — but you are a bit stuck. Your Sorrento short turned into (1) a Sorrento short (fine, great, buy the stock back for less than you sold it for and make a profit) plus (2) a Scilex short: The dividend left you short some Scilex shares, and it is hard to buy those back because most Scilex shares are not tradeable. Meanwhile you are probably paying a lot to borrow those Scilex shares. Some brokerages “have charged short-selling customers as much as 300% interest per annum for borrowing any shares for short-selling,” says the equity committee, in the lawsuit in which it also claims that all of the short sales are phantom shares and not actually borrowed at all.
Anyway Sorrento and its equity committee hit on a solution to the alleged problem of phantom shares: Sorrento would give the “dividend short holders” the “exclusive opportunity to purchase … restricted Scilex stock … for the sole purpose of covering their short positions … and to the extent applicable, delivering the borrowed shares to the lenders thereof.” And “the Dividend Short Holders shall receive releases of any and all claims that Sorrento and Scilex may have relating to any naked short-selling and claims.” Or the short holders could buy shares in the open market, deliver those shares to their share lenders and get the release from the supposed naked-shorting claims. The equity holders wrote:
The Debtors and the Equity Committee have also explored potential direct claims against the customers of the Brokerage Firms that have engaged in naked short-selling. Given the status of the Chapter 11 Cases and the cost, complexity, and delay of filing litigation against these parties, the Debtors and the Equity Committee have determined to pursue a “win-win” resolution of these disputes directly with the Dividend Short Sellers. …
The Offering provides an entirely voluntary, efficient and cost-effective method of resolving any potential claims held by Sorrento and/or Scilex against the Dividend Short Sellers, allowing the Dividend Short Sellers to cover their short positions, and providing the Debtors with much-needed liquidity for the estates and the Debtors’ restructuring efforts.
The brokerage firms were horrified, sending in a “statement” to “clarify for the record that Defendants have not agreed and do not agree to the ‘term sheet’ attached to the Motion despite the Movants’ unilateral listing of the Defendants as a ‘party’ to it”:
Moreover, the “settlement agreement” that Movants ask the Court to authorize does not purport to resolve the Adversary Proceeding. Instead, the Movants propose to settle unripe, future disputes with non-parties to the Adversary Proceeding, the so-called “Dividend Short Sellers.” To the extent that the Motion can be construed as seeking an order from the Court compelling the Defendants to “require” their clients to take action with regard to their short positions Defendants oppose the Motion. Any resolution the Debtors and Equity Committee reach with the so-called Dividend Short Sellers should not impose any obligation on Defendants (who are not Dividend Short Sellers) in the Adversary Proceeding. Moreover, Defendants are perplexed by the Movants’ position that the Motion—setting forth a complex securities offering—must be heard on an emergency basis and question why the Movants would ask the Court to consider a settlement proposal that neither Defendants nor any other party (to the knowledge of Defendants) has even suggested that they would accept. Indeed, the Dividend Short Sellers, to whom the proposed settlement and offering are directed, appear to have no notice that either the settlement or the proposed offering even exist.
Basically Sorrento has reached a “settlement” entirely with itself, and has just presumed that people with Scilex short positions will accept the deal, without asking them. Nonetheless the judge approved this last week, and Sorrento announced the offering:
The Dividend Short Holders can purchase the Restricted Scilex Stock either in open market purchases or in private, secondary transactions with Sorrento at a price to be determined by Sorrento's Chief Restructuring Officer, in consultation with the Official Committee of Unsecured Creditors and the Equity Committee. In connection with the Offering, an Information Memorandum was distributed via FedEx and emailed to approximately 160 brokerage firms or record holders of short positions in Restricted Scilex Stock on July 20, 2023 pursuant to the Order. The deadline to participate in the Offering is July 31, 2023, subject to any extensions granted by Sorrento following consultation with the Equity Committee.
I suppose this has some appeal for everyone:
If you were short Sorrento, and are now short Scilex, you can conveniently buy in your shares and close out that short. (At a profit? Scilex is also down since January, though it’s a little unclear what price Sorrento would get for the shares. “The pricing of all sales by Sorrento to the Dividend Short Sellers described in the Offering shall be determined by the Debtors’ Chief Restructuring Officer in consultation with the Creditors Committee and the Equity Committee,” says the judge’s order.)If you are Sorrento’s equity committee and worried about naked shorts, and all the shorts are closed out, then I guess you can be satisfied that none of them were naked? Or something? I don’t know. If you are Sorrento, you get to raise cash by selling more shares of Scilex stock, to the short sellers.But the offering is “entirely voluntary,” and if short holders want to keep on their bets against Scilex I guess they can. They are presumably paying a lot to borrow the stock, and the position might be hard to close out later since, you know, who knows what will happen next here. Here is an FAQ that Sorrento issued today:
Sorrento, Scilex and Scilex Dividend Short Holders (“Buyer”) will execute a stock purchase agreement providing for the sale of Scilex common stock by Sorrento to Buyer (the “Purchase Agreement”). The shares will be sold pursuant to the Registration Statement on Form S-1 (File No. 333-268603) filed by Scilex with the SEC on November 30, 2022, and declared effective by the SEC on December 27, 2022 (the “Form S-1”).
Sorrento will instruct Scilex’s transfer agent to transfer the shares to the Buyer. The shares will be recorded by Continental in book entry format.
As set forth in the Purchase Agreement, Scilex will instruct Continental to “waive” application of the Lockup solely for the purpose of Sorrento’s sale of the shares to the Buyer. The Lockup will continue to apply to the returned shares in Buyer’s name.
If the Buyer is using the shares to cover all or a portion of any outstanding short position in Scilex stock, Buyer will instruct Scilex’s transfer agent to transfer the shares to the lender of the short position. This same process will apply if the lender is also a borrower of Scilex shares (i.e., short) and, in turn, is returning the lender’s borrowed shares to a downstream lender.
Scilex will further instruct its transfer agent to “waive” application of the Lockup solely for the purpose of Buyer conveying shares to the lender. The Lockup will continue to apply to the returned shares in lender’s name. This same process will apply if the lender is also a borrower of Scilex shares (i.e., short) and, in turn, is returning the lender’s borrowed shares to a downstream lender.
Also, the day after the judge approved all of this, Scilex announced its own $75 million public stock offering, though that … seems unrelated? “We expect to use the net proceeds that we receive from this offering for working capital and general corporate purposes,” says Scilex, though it goes on to add that it might use some of the money to help out Sorrento. “We do not currently know whether any such share repurchase transaction or additional debt financing transaction with Sorrento using the proceeds from this offering would ultimately be approved by the independent conflicts committee,” though.
I don’t know what to tell you! All of this is weird, starting with Sorrento’s decision to hand out a bunch of property to its shareholders shortly before filing for bankruptcy, and going through its decision to hold a special stock offering to help short sellers close out their positions.
Mostly though we have talked a few times about the very popular, long-running and always very perplexing to me conspiracy theory about how big Wall Street banks are conspiring to print millions of phantom shares for naked short sellers to use to drive down the prices of innocent companies. This theory is generally presented without evidence, or with misleading evidence (“short interest is higher than the float!” etc.), but it seems very durable. Here it is again! |
