Re: 6/10/02 - [EATC/ELAW/JNOTE/NPCT/Kernaghan] Forbes: Sinking Fund
Sinking Fund
Brandon Copple, 06.10.02
Have financiers torpedoed struggling small companies they were supposedly helping? Lawsuits raise some ugly accusations.
Rodney Young thought he'd hit the big time. For months he had been casting about for cash to save his young telecom-services outfit, Eagletech Communications. Then in March 2000 he sent a team of executives to New York to meet a group of potential investors at Salomon Smith Barney. Young had a patent, but no sales, and yet here were five Salomon officers and a group of investors offering to buy convertible preferred shares from Eagletech for up to $6 million. "I thought these people wanted to help us," he says.
He was soon disabused of that notion. Immediately after the meeting at Salomon, Eagletech's share price began to sink. By November it was down from $14 to 75 cents, erasing $113 million in stock market value. That seemed extreme even for a company that had only $300,000 in cash and was burning $100,000 a month.
Young now claims the wave of selling was led by the very investors at Salomon's table. In a suit filed in Florida, where Eagletech is based, Young alleges that mighty Salomon, along with a group of conspirators, set him up for a fall with convertible-debenture financing, then shorted the common stock all the way down. Salomon has asked the court to throw out the complaint, claiming it did nothing to harm Eagletech.
Eagletech's suit is one of five similar actions. They are led by John O'Quinn, a rapacious plaintiff attorney in Houston who has conjured multimillion-dollar verdicts in breast implants and tobacco. Much of the legal legwork is being done by another Houston lawyer, James W. Christian. Each complaint has been filed on behalf of puny companies against well-heeled financiers who allegedly offered desperately needed capital and then profited by short-selling of shares--all in the thinly regulated world of Bulletin Board stocks. One plaintiff, a legal-research outfit known as Internet Law Library, says it has identified more than 100 companies damaged in convertible-securities schemes, resulting in billions of dollars in lost market value.
The kind of financing at issue, since discredited, goes by the telling name of "death spiral preferred." It worked like traditional convertible securities, except that the conversion price was a movable goalpost. The more the stock went down, the more shares the owner of the convert could claim on converting.
In malevolent hands, this kind of convert could produce a windfall for the owner of the preferred and disaster for the company that issued it. Suppose a company's common stock is trading at $10 and you provide $5 million in convertible financing. In a conventional convert deal, the preferred would be exchangeable for, say, 400,000 shares. In the death spiral variety, the holder of the convertible is entitled to $5 million worth of shares, whatever their price. So you might buy the convertible preferred and immediately short 500,000 shares of common stock. If the stock sinks, you could short more. You might run the stock down to $1, pocketing, say, $20 million on the short sale of 10 million shares. Now you convert your preferred shares, demanding the 10 million common shares you're entitled to and using them to cover short sales. You have shelled out $5 million and collected $20 million.
Whether anything this blatant happened is a matter of dispute. What's certain: Plenty of companies with death spiral financing saw their common shares go into death spirals. Somebody was selling all the way down, and those sellers may have been in cahoots with convert holders.
In O'Quinn's cases the alleged conspirators range from top-tier investment banks like Salomon to mysterious Caribbean-based straw entities. The suits single out two active players in convertible deals: Mark Valentine, former chairman of Canadian brokerage Thomson Kernaghan; and Steven Hicks, president of Southridge Capital. Proving that they either shorted stocks or worked with others who did won't be easy.
The defendants say the allegations are completely unsubstantiated and have asked the courts to dismiss the cases. Michael Rosenblum, an attorney defending those suits, says even if the allegations are true, it doesn't constitute stock manipulation. Thomson Kernaghan is suing one of the plaintiffs, Nanopierce, for defamation in Canada.
According to the suits, Hicks arranged convertible financing for desperate companies, then the investors directly or indirectly shorted the borrowers' stock through Valentine's brokerage, covering their trail by running sales through U.S. and offshore brokers and marketmakers.
The outside investors may not even exist. Internet Law Library claims in its suit that the "investor" buying its convertibles--Cootes Drive LLC, named after a street where it is based in Grand Cayman--was a shell. The entity's correspondence is sent care of Citco Trustees, which is part of Citco, a private financial services company that claims to have $88 billion in assets. Citco hasn't been sued.
The victims were smallish companies traded on the Nasdaq Bulletin Board. Christian and his clients claim the Canadian bankers and others exploited lax oversight of this market by the National Association of Securities Dealers, selling stock they didn't have--"naked" short-selling. Stockbrokers can sometimes get away with it, if the buyers of shorted shares don't demand to see the certificates.
It's on this very point that one alleged victim has decided to fight back. Gary Valinoti, chairman of JagNotes.com, a tiny media company, needed cash to build a TV station for his online stock-news service. So he agreed to take down $10 million in convertible preferred financing. It seemed to be a better deal than selling common at $3 a share.
As soon as JagNotes booked the investment, the share price began to fall. Much to Valinoti's puzzlement, the stock continued falling, in good times and bad. He was further baffled by the list of large shareholders, required to disclose their holdings each month, which showed no selloffs. And yet by February 2001, the stock was trading at 10 cents. "Everybody I knew was buying, but who the hell was selling?" Valinoti wondered.
He concluded it had to be naked short-sellers. Instead of suing his tormentors, Valinoti decided to call their bluff. In February 2002 he announced a recapitalization plan, reconstituting JagNotes common stock into new Class A and B shares. To receive new issues, shareholders had to hand in their old stock certificates.
The recap took effect Apr. 8. As brokerages began sending in certificates on behalf of their clients, gaps appeared. Citibank's beneficial holder list, for example, accounted for 6,300 shares; one investor claimed he owns 1.2 million shares through his Citibank account.
Brokerages that didn't bother to demand certificates when clients bought JagNotes shares are in a jam. Morgan Stanley has a deficit of 500,000 shares, reports JagNotes. UBS Paine Webber seems to be missing 252,000 shares. Eventually brokers must collect from whoever sold them the phantom shares. Meantime they may have to buy on the open market to cover their clients' positions. That should drive up the shares of JagNotes and generate a windfall for Valinoti, who owns 5 million shares. Recent price: 39 cents.
Expect a fierce fight. O'Quinn has already spent about $3 million on discovery. He'll keep spending because, he says, "This could be bigger than tobacco."
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