Harrold, I thought that a visual explanation of the way the floorless bandits make money should be helpful on this site, so here it is.
Let us assume that the size of the debenture is $10 MM, and that on the issue date the stock into which the floorless is convertible is at $10/share. When the buyer of the floorless has a piece of paper in his hand saying that he owns the floorless, he deposit it in his "margin" account (he might not even have paid for that since in such PP actual payment can be delayed until "closing". He now shorts 1 MM shares which is exactly the face value of his floorless. This
shorting will "soak" buying power from that market, particularly if the issue trades only
few hundred thousand shares per day. Note, that with his $10 MM that he got he now
pays for the floorless (or replace the money he laid out for the floorless). Thus he has no
more money committed to this stock whatsoever, but he making the 5% to 10% on the
floorless as interest.
His shorting causes the stock to go to let say, $7.5/share. Well, at this price (without
discounts) the floorless is convertible to 1.333 MM shares, so he shorts another
333,000 shares and get credited about $2.5 MM. That puts additional pressure on the
stock bringing it to $5/share, which cause the floorless to be convertible to 2 MM
shares. Guess what, our bandit goes out and short another 670,000 for which he gets
$3,35 MM (so on no cash invested he gets the interest and so far $5,8 MM). By now
everyone knows that the company is in trouble (it would not have agreed to a floorless
feature if it could access "normal markets"), and the stock drops sharply to $2.5 share
equivalent to 4 MM shares. The bandit tirelessly (it becomes problematic to find shares
to borrow, but he works hard in cohoot with market makers) short another 2 MM
shares for which he pockets $5 MM. Let say he knows wants to stop the game (some
of these guys bring the stock all the way to the pennies range before they finally quit), he
DOES not buy back his short at all, he tells the company to convert his debenture at the
new low price of $1.75 or (without discount) to about 5.7 MM shares, he delivers 4
MM shares against his short position and sell the balance for an additional profit of
about $3 MM. So, for a few weeks (if at all) of risking his $10 MM, which he
recovered, and then on no investment, he made about $14 MM in Cap gains, and if it
took a year, another $.5 MM in interest. The original $10 MM was of course deployed
into the next floorless.
What people do not understand is that the floorless piece of paper is the collateral he
uses all the time, not cash, and thus unlike other shorters that need to keep 50% cash
against their short, he does not even have to do that. Furthermore, the company thought
that it will have just another 1 MM shares and ends up (in this case) with another 5.7
MM shares. There are many cases where the shares are actually converted for pennies
and the 1 MM shares turns to 100 MM shares, followed of course by seeking approval
to increase the number of shares from stock holders (now the floorless himself, many
times) and that is followed by reverse splits and all other equity shrinkage events.
A stock holder staying long in a company that issued a floorless has no business
investing in anything but a mutual fund.
Zeev |
