Eventhough the following article does not mention NRID, you can make comparisons nevertheless. Unfortuanately!!! I guess you can only learn from your mistakes.
May 17, 1998
If 'Toxic Convertibles' Drive Up, Watch Out for Sinkholes
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By RICHARD KORMAN
hey call Peter Davis almost daily, strangers who say they want to help his Xoma Corp. close the gaps in its finances. Many promise an immediate infusion of cash in exchange for a certain kind of preferred stock.
But Davis, chief financial officer of the biotechnology company in Berkeley, Calif., says he is on to their game. "We get calls from all over the place and try to steer away from these folks," he said.
As if fledgling high-technology companies didn't have enough problems, now they have to worry about predatory investors who try to drive down the price of the shares they have bought through high-volume short-selling -- that is, by selling borrowed shares, replacing them later at a lower price and pocketing the difference.
These investors are able to turn the financial desperation of high-technology companies, which often swim in red ink for years before developing marketable products, into big profits for themselves at the expense of existing shareholders.
They do so by perverting a complicated financial transaction known as a convertible-preferred-share placement. Such a transaction can legitimately serve as a lifeline to promising but financially struggling businesses, advocates say.
Extremely rare only a few years ago, these deals now number in the hundreds annually, according to analysts. But the companies that do them don't always understand the risks.
"Entrepreneurs who manage these companies are creatures of hope who always believe they can make a profit on the cash from these financings," said Marcus Robbins, editor of the Red Chip Review, a newsletter that covers small publicly traded companies. But, he added, they "don't always know what they are getting involved with."
The transactions work this way: The company sells the investor a new issue of convertible-preferred shares -- shares that have priority claims on dividends and assets and can be converted to common shares -- through a private placement.
The placement includes a 1990s twist: Instead of the more usual practice of fixing ahead of time how many common shares would be received, these preferred shares are convertible at a floating ratio based on the stock price.
The lower the stock price happens to be when the investor decides to convert, the more shares the investor would get. On top of that, the deals may include a discount of up to 30 percent, giving the converting investor even more common stock in exchange for the preferred.
Firms that invest in such financings say they are a boon to innovative but cash-short companies. "This is a huge industry involving many of the biggest investment banks on Wall Street," said Mitchell Kaye, a principal of Brown Simpson Asset Management in New York. He estimated that more than 1,000 deals worth several billion dollars will be concluded this year.
Even so, some people on Wall Street call such deals "junk equity." (Issues of debt securities with similar conversion features are also growing more common, and pose similar risks.)
Robbins of Red Chip Review calls some of them "toxic convertibles" because they offer an immense incentive for unscrupulous investors to drive down the share price by selling the stock short. Generally, when a large number of short positions is taken in a thinly traded stock, the price falls.
Such short-selling is illegal if used to manipulate the market for profit. And big profits are clearly possible: Once the price is down, an investor can convert preferred shares for large amounts of the company's common stock, use some to repay the borrowed shares, bank profits from the short sale and own as many shares in the company as when he started, or more.
To be sure, most investors in convertible preferred securities with such a protection against falling share prices don't short the stock.
But whether or not short-selling occurs, shareholders upset at price declines that coincide with such share conversions can react angrily. Last November, for example, shareholders of the Illinois Superconductor Corp. in Mount Prospect, Ill., filed a lawsuit against the company's managers and directors, accusing them of breaching their fiduciary responsibilities by arranging a $15 million private placement of preferred convertible shares to Southbrook International Investments Ltd. under terms that encouraged Southbrook to short Illinois Superconductor's stock.
According to the lawsuit, Southbrook, which is based in the British Virgin Islands, or its agents engaged in short sales to drive the price down and thereby collect more common shares in return for preferred stock.
As a result, the share price fell from $12.375 to $11 within a few days last June, then from $9.75 to $7.625 within a similarly short span in August and finally dipped below $1 by December, the complaint says.
One of the plaintiffs, the money manager Sheldon Drobny of North Brook, Ill., says he and his investors took a $9 million hit as a result of the short-selling. He also claims that the operation more than doubled the number of Illinois Superconductor shares, sharply watering down their own shares' claim on future profits.
"Last year at this time, there were five million shares outstanding, but at this year's annual meeting there were 12 million. That's a significant number," said Steven Shapiro, Drobny's lawyer.
Edward Laves, Illinois Superconductor's chief executive, denied that he or his fellow managers and directors acted irresponsibly. He characterized the lawsuit as retaliation for a suit the company filed last spring against Drobny and other shareholders in a dispute over financing.
Laves added that the convertible placement was Illinois Superconductor's only financial option after a failed secondary public offering. He said the company was now on the rebound, with the stock now trading at around $2.75.
He attributed the share-price declines of last year to his company's disappointing results and to general market trends, not to short-selling. "The market wasn't being nice to microcap technology stocks," he said.
Illinois Superconductor, which commercializes high-temperature superconducting technology for the wireless telecommunications industry, has raised about $50 million in private and public offerings since it went public in 1993.
Southbrook, which was not named as a defendant, could not be reached to comment on the accusations made in the lawsuit. Brown Simpson Asset Management, which participated in the financing, declined to comment on the complaint or to provide information about Southbrook.
Whatever the merits of that case, predatory short-selling in conjunction with junk-equity offerings appears to be on the rise. Gerald T. Kennedy, president of Kennedy Capital Management in St. Louis, said his company had taken its lumps several times the last few years.
"We've been hurt; we've been bruised," Kennedy said. "We actually had this happen in six instances, and almost every time it's a disaster."
Kennedy sends companies in which his fund holds a position a letter, urging them to be on the lookout for bad convertible preferred-stock deals. "We are bringing this scam to your attention because we do not want to see companies in which we invest attacked by these vultures," he warns them.
Because private placements need not be disclosed in advance under Securities and Exchange Commission regulations, existing shareholders often have no idea what has hit them.
And when the financial transactions are spelled out weeks later in filings with the SEC, the details are often so complex that an the average investor can easily overlook the danger.
Even deals in which no short-selling takes place can stir up trouble. For example, an investor in Bio-Imaging Technologies, a medical-technology company in West Trenton, N.J., that recently concluded a bitter battle over board membership, converted a large chunk of preferred shares for as little as 63 cents, helping drive the stock price so low that NASDAQ threatened to delist the company.
Another company, Geotek Communications Inc., a wireless communications company in Montvale, N.J., has scattered its equity over so many financings that it was forced to acknowledge in a recent SEC filing that it cannot calculate how many shares it might have to issue to holders of preferred stock.
Ordinary stockholders who want to avoid being burned by market manipulators can take some basic precautions: keeping track of new financings by companies in which they own shares and getting out when a deal is announced on unfavorable terms.
The Diaz & Altschul Group, a New York firm that arranges and invests in convertible financings, says it simply shuns deals that encourage investors to profit from a falling stock price.
Arthur Altschul Jr., a founding partner, said companies could protect themselves against short-sellers by avoiding deals that allow investors to convert preferred shares at a deep discount to the market price; by insisting on the right to redeem an issue without onerous penalties, and by demanding covenants against short-selling and pledges to comply with SEC regulations.
Brian Pusch, a securities lawyer, says preferred stock that pays an automatic dividend is less likely to come under attack by short-selling investors than stock that does not.
Other specialists counsel companies to limit the size of private placements and to put a ceiling on the number of shares that may be obtained through conversion if the stock price falls.
But then again, companies worried about survival will often agree to just about any terms. "What is implied is that a company is very high risk, and this is the only financing scheme anybody is willing to provide funds for," says Robert Natale, a former investment analyst at Standard & Poor's who is now with Bear, Stearns.
The SEC's guidance in junk-equity financing is a work in progress. The agency says it is eager to stamp out "abusive practices." But just what qualifies as illegal stock manipulation depends on the situation, says David Sirignano, associate director in the SEC's division of corporate finance.
In any case, most junk-equity deals probably do more good than harm. "The role they are playing is to fill the gap on high-risk technology," says James Donaghy, chief executive of Sheldahl Inc., a computer technology company in Northfield, Minn., which has made several private placements of convertible-preferred shares. Sure, he added, there is always the danger that his company's stock will be shorted.
But, Donaghy said, "People just have to understand they are in that kind of business."
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