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01/05 08:57
Dot.coms Feel Pinch of `Death Spiral' Loans, Some by CSFB Unit
By David Ward
San Francisco, Jan. 5 (Bloomberg) -- Lenders call them ``floorless'' or ``floating'' convertible loans, and for many money-losing Internet firms, they are the financing of last resort.
The loans are given another name by detractors: ``death spirals.'' That's because companies' stocks often have plunged after they took out these loans. Terms of the borrowings typically call for the lenders to be repaid in stock, and the farther the stock falls, the more shares the borrower must pay.
Critics, including some of the chastened companies, charge that in certain cases the lenders themselves contributed to the stock declines by selling the shares short -- selling borrowed stock -- to force the company to give it more shares. In other cases, critics charge, just news of the loan spurs traders to short the company's stock.
Some companies and investors argue ``death spiral'' loans contributed to declines in the shares of Intraware Inc., EToys Inc., Entrade Inc., Log On America Inc., RoweCom. Inc., Intelect Communications Inc., Shop at Home America Inc. and others.
``What everyone worries about is that you do this and your (lenders) will try and drive the shares down,'' said Mark Long, an executive vice president at Intraware, an Emeryville, California- based provider of Internet software whose shares have dropped 92 percent since it borrowed $25 million last June.
While many of the controversial loans have been linked to lesser-known hedge funds, Marshall Capital Management Inc., a wholly owned subsidiary of Credit Suisse First Boston Inc., has been the lender in several cases, and has been named in a lawsuit filed by a company that borrowed from Marshall and others.
Typical Death Spiral
In a typical death spiral loan, a company borrows money at a set interest rate, but agrees under certain circumstances to pay off what they owe with their stock. The loans specify that a dollar amount in shares be paid, so if the stock falls, a greater number of shares is needed to satisfy the lender.
In the worst-case scenario outlined by critics, the lender ``shorts'' the stock and pockets the proceeds from that sale. The short-selling helps push the stock lower. The lender then forces payment of the loan in shares, which he can use to pay back the stock he borrowed. And the farther the lender can push down the stock, the more shares he can claim, and the more he can sell short for a profit.
Some caveats are order. Companies that resort to death spirals are desperate and their shares are ripe for a fall, meaning their shares are inviting targets for all short-sellers. The fact that the companies often have shopped around for convertible loans, making their plight well-known, increases the danger that their shares will be seen as a tempting short sale. What's more, firms that make any kind of convertible loans often short the stock involved as a hedge against potential declines in the shares they might get to pay off the loan.
Lawsuits
Still, at least three lawsuits have been filed in the past two years accusing lenders of ``floating'' or ``floorless'' convertible loans of purposefully shorting the stock in an effort to drive down the stock price and collect more shares.
CSFB's Marshall unit and two other lenders were accused in a suit filed by Log On America, a Providence, Rhode Island, Internet- access provider, of illegally manipulating the price of its stock, according to a suit filed in New York last August. Marshall denies the charge. CSFB itself isn't named in the suit.
Log On America borrowed $15 million last February from a group that included Marshall Capital, along with New York-based hedge fund Promethean Asset Management LLC, and Chicago convertible loan issuer Citadel LP. The company sued after its shares fell more than 80 percent.
Short Selling
The suit claims that that the lenders illegally profited by ``massively'' selling short Log On America shares, pushing down the price of the little-traded stock. The suit claims the lenders then attempted to force the company to convert the loan into stock so they could use those shares to cover, or pay back, the stock it had sold at a higher price.
Marshall Capital and Promethean deny that they shorted Log On America stock. A spokesman for Citadel says the company believes the suit has no merit.
Though CSFB isn't named in the suit, Log On America Chief Executive David Paolo said in an interview that his company consulted with bankers at CSFB about the loans before going ahead, and that CSFB referred the company to its Marshall subsidiary. ``CSFB was our financial adviser during the time,'' Paolo said. He declined to say whether CSFB was paid for its advice. CSFB declined to comment on the suit.
Downplays Connection
Parent CSFB downplays its connection to Marshall. A search of the company's Internet site found no mention of Marshall and a CSFB spokesman declined to comment on the firm's relationship with Marshall Capital.
Yet papers filed in the suit show that Marshall's board includes three high-ranking CSFB managing directors -- John McAvoy, head of global convertible capital markets; Thomas O'Mara, head of convertible trading; and Paul Calello, global head of the equities and convertible bonds.
McAvoy, O'Mara and Calello declined through a CSFB spokesman to comment, although CSFB didn't deny their affiliation with Marshall Capital. Alan Weine, the president of Marshall Capital, also denied requests for an interview.
`Backed by CSFB'
Intraware and Pilot Network Services Inc., an Alameda, California, company providing secure Internet connections, have also seen their stocks get hammered after taking convertible loans from Marshall Capital -- though neither company has filed a lawsuit over the matter.
When it was unable to find traditional financing, Intraware said it turned to Marshall. Long, the Intraware executive, said part of the reason was Marshall's affiliation with CSFB. CSFB led Intraware's initial stock offering in February 1999. ``Marshall is backed by CSFB,'' Long said. ``CSFB had a stake in making sure the Marshall guys were treating us well.''
Nonetheless, the number of shares sold short in Intraware rose more than threefold during the month it negotiated the loan from Marshall. Long said he didn't know who was shorting the company's stock.
Intraware shares, which had already dropped 75 percent that year, continued to fall after the company announced the loan. Intraware repaid about $16 million of the $25 million loan within three months of borrowing it. ``I don't know if we'd do it again,'' Long said. ``We'd be more cautious.''
Pilot Network Services borrowed $14 million from Marshall last June, according to filings with the Securities and Exchange Commission. Since then, Pilot's stock has dropped 95 percent. Pilot filed with the SEC in October giving Marshall Capital the right to convert part of its loan into 1.5 million shares.
Analysts say that the loan could have spurred some traders to short the stock. The short interest in the company's stock rose from 343,000 in May to 995,162 in June and 1.2 million in July.
Pilot Chief Executive Marketta Silvera and Chief Financial Officer Donald Marsee didn't return repeated calls for comment.
CSFB led Pilot's initial stock offering in August 1998.
Prometheus of Myth
Promethean Asset Management has been named in two other lawsuits by borrowers. One was filed by drugmaker Ariad Pharmaceuticals Inc. Another was filed by fiber-optic-equipment maker Intelect Communications Inc. and that suit also named Angelo Gordon & Co., a New York-based hedge fund.
Both suits allege the lenders sold them convertible loans and then purposefully shorted shares of their stock. The suits were settled and the terms were not disclosed.
A spokeswoman from Angelo, Gordon said the company doesn't talk to the press and wouldn't comment.
Promethean founder and Chief Executive James O'Brien also declined requests for an interview and wouldn't discuss specific loans. He did respond in writing to a list of written questions. ``Every one of our investments becomes more valuable as the issuer's stock price increases, and conversely, every one of our investments becomes less valuable if the issuer's stock price declines,'' this document said.
(Prometheus is the mythical Greek figure who, because he had stolen fire from the gods to give to humans, was chained to a rock and condemned to have his liver pecked at by eagles for eternity.)
EToys
Promethean also was the lead investor in a $100 million loan to EToys Inc., a money-losing Internet toy retailer. EToys borrowed from Promethean and Citadel in June. After its stock had plunged 74 percent, EToys renegotiated the loan to delay part of the conversion of the loan into stock until January.
Nonetheless, in regulatory filings in December, EToys said Promethean and Citadel had converted more than 72 percent of its loan into 36 million shares. The lenders aren't required to say if and when they sell the stock, and an EToys spokesman declined to say whether the lenders had shorted the stock.
High Risk
Analysts say the loan isn't fully to blame for the decline in EToys' shares. EToys said last month its sales for the holidays would lag estimates, and its stock has dropped to less than $1 from over $60 in December 1999. The company says it will run out of cash at the end of March and has hired Goldman, Sachs & Co. to pursue options that might include the sale of the company. Yesterday EToys said it would fire 700 of its 1,000 employees.
``If the capital markets have turned you away, you're going to talk to (lenders) willing to take on high-risk situations,'' said Kevin Silverman, an ABN Amro Inc. analyst who ranks EToys ``sell.''
Some analysts say the big losers in these instances are the shareholders who owned the stock before the loan was issued. A study of almost 500 death spiral convertible loans issued between 1995 and 1998 -- by two French finance professors studying at the University of California -- found that in 85 percent of the cases, companies' stocks fell after they borrowed the money, losing on average about a third of their value within one year -- even as the broader Standard & Poor's 500 Index rose.
``The real victims are the people who own these shares'' before the company enters into the loans, said Theo Vermaelen, one of the authors of the study.
Steep Price
Several companies have gotten out of the loans, but at a steep price. Entrade, which designs Internet marketplaces for trucking and textile companies, borrowed $28.6 million from Promethean and Angelo Gordon, closing the agreement last March 27, according to regulatory filings. Entrade shares closed at $41.88 that day. After Entrade shares had declined 70 percent in three weeks as investors fled Internet shares, Entrade repaid the loan, giving Promethean and Angelo Gordon the $28.6 million, plus a $5.4 million penalty, filings show.
Entrade Chief Financial Officer Norman Smagley confirmed the terms of loan but declined to comment further.
Fast Spiral
RoweCom, a Cambridge, Massachusetts, online provider of books and journal subscriptions, borrowed $20 million from Promethean and Angelo Gordon in October 1999, and the loan said that the lower RoweCom's stock fell, the more shares it would have to pay the lenders. RoweCom, whose financial losses were mounting, saw its stock drop 99 percent last year.
Promethean and Angelo Gordon converted about $5.7 million into stock in four days until the company repaid what was a six- month-old loan, along with an almost $2 million penalty, rather than risk issuing more stock and diluting the value of its shares, RoweCom Chief Financial Officer Paul Burmeister said in an interview.
Burmeister said the lenders had the right to short the stock and he said he believed that they did so. ``I think that the volume of shorting they were permitted to do added to the downward pressure on the stock,'' Burmeister said.
``I think they find a way to profit from a company's misfortune,'' he said.
Shop at Home America Inc., a home shopping TV network, also was indebted to Promethean. It borrowed $20 million from Promethean and others last July. Since then, its shares dropped 81 percent. In the month after it signed the loan, the short interest in the company's stock rose more than fourfold, from 286,735 shares in July to 1.25 million shares in August, according to Bloomberg data. The short interest at the end of December was 3.3 million shares.
``Management never had a full appreciation of what they were getting involved with,'' said John Ray, president of Legacy Asset Management Inc., which owns the company's shares. ``If they did, they never would have gone near that deal.''
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