Diamondcutter:
The example is reproduced below:
Let's see what can happen: Suppose we have a company with eight million shares outstanding and the market price is $8 a share, so its market capitalization is $64 million. The predatory investor provides $10 million of capital via convertible preferred stock. Under the convertible terms, the stock will be convertible at the average closing price during the lowest five-day price period prior to conversion. The company thinks that with the influx of new money, the stock should be strong, but even if it slips to $6 a share, the new investors will only get 1.667 million shares ($10 million ö $6 = 1.667 million shares), which would amount to 17% of the company [the company would have total shares outstanding of 9.667 million (8 million + 1.667 million); 1.667 million ö 9.667 = 17%].
But suppose convertible investors start to short the stock, pushing the price down [when you short a stock, you sell the shares at a specified price for delivery at a future date, anticipating that the price will be lower when the shares must be delivered]. At $6 a share, they can short 1.667 million shares, with it being considered a hedge rather than a pure short because they are long the convertible (they own the underlying shares). But shorting that much could easily drive the stock down to $3 a share. At that price, they can convert into 3.33 million shares, which means they can short an additional 1.667 million shares, driving the price to $1 where they can establish their conversion price and convert into 10 million shares. They would then use 3.33 million shares to cover their short position, generating a profit of $15 million (they received an average of $4.50 a share on 3.33 million shares for the short sales; $4.50 x 3.33 million = $15 million).
Thus, after converting their investment of $10 million, they have a $5 million profit, plus they own 6.667 million shares, which amounts to 37% of the company's 18 million shares outstanding (8 million + 10 million). At this point, they can hold onto those shares if they choose, or sell the balance slowly as the stock starts to retrace.
It could have been worse. And unless someone can prove intent, it is very difficult to bring a civil suit. So how can this type of activity be stopped?
Well, of course, if companies wouldn't subscribe to such offers, they wouldn't exist, but a desperate company will do most anything to stay in business because they have hope. The predatory investor doesn't care-he can make a profit whether the company stays in business or not.
Legislation is difficult because short sellers serve a market function, and hedging is often justifiable and necessary.
The market itself could reduce the occurrence. If hedge funds and larger investors would buy stock of such companies at the right time, they would reduce the impact and make additional profits. This, however, is a tricky type of investing.
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