AT DEATH’S DOOR.
March 12, 2002
Death Spiral Financing. The name says it all. It conjures up the image of a process that is spinning out of control, toward inevitable doom. It is a disaster for companies and their shareholders. Yet desperate companies, needing immediate financial help, succumb to the temptation of short-term aid, only to suffer its long-term ill-effects.
How did death spiral financing earn its unsavory reputation? It works like this. A lender agrees to loan money to a company in exchange for a convertible debenture that bears a reasonable rate of interest. But there’s a catch. The lender is entitled to convert the debenture into shares of the company’s common stock, but the conversion rate is a moving target rather than a fixed, predetermined number of shares.
For example, in exchange for a loan of $1.5 million, the debenture holder may elect to receive $1.5 million of the company’s stock – usually at a discount from the prevailing market price. The number of shares the holder receives will depend on the stock price at the time of conversion. Consequently, the lower share prices go, the more stock the debenture holder gets.
This presents a problem, and an opportunity for abuse, since the debenture holder benefits if stock prices decrease. Unfortunately, in order to take advantage of this process, some debenture holders sell the company’s shares short, hoping to drive down the price. As share prices dip, the debenture holders keep on selling short, pocketing more and more proceeds on the way down.
To illustrate this, consider the case where an investor is entitled to convert a debenture into $1.5 million worth of common stock. If the debenture holder were entitled to convert the debenture into a fixed number of shares – say 500,000 – he or she would have no incentive to see the stock price go down. To the contrary, if the stock price increased, so would the value of those 500,000 shares.
But look at what can happen if the debenture holder stands to get more shares as the stock price decreases. If the company’s shares were trading at $5 when the debenture was issued, the debenture holder might start out by selling short 500,000 shares and pocketing proceeds of $2.5 million. If the stock is not heavily traded (as is the case with most microcap companies) those sales could help drive the price of the stock downward.
As prices fall to $3, the debenture holder can short another 500,000 shares and realize $1.5 million more. There would be no need to stop. When the stock decreases to $2 per share the debenture holder can short 500,000 more shares for another cool $1 million. At that point he or she will have profited to the tune of $5 million.
In our hypothetical situation, when the stock reaches $1, the debenture can be converted into 1.5 million shares. The debenture holder may then deliver those shares to cover the outstanding short position. It’s that simple. For a $1.5 million loan, the debenture holder winds up with $5 million – a cool $3.5 million profit.
Death spiral financing can be a death knell for the company whose stock is battered by this practice.
Regulators are taking notice of this problem, as reflected in an action initiated by the Securities and Exchange Commission on February 26, 2003 against an unregistered investment advisor, Rhino Advisors, Inc., and Rhino’s President, Thomas Badian.
Rhino and Badian were charged with engineering a death spiral financing scheme to benefit one of their clients. The SEC complaint alleged that Rhino and Badian manipulated share prices for the common stock of Sedona Corporation by engaging massive short selling in order to enhance the value of a $3 million Convertible Debenture that had been issued by Sedona on November 22, 2000.
Rhino’s client had provided $2.5 million in financing to Sedona in exchange for a $3 million 5% Convertible Debenture that was due on March 22, 2001. The Debenture included a conversion formula that permitted the client to convert all or any portion of the Debenture into Sedona common stock at a discount to the market price – roughly, 85% of the price of Sedona stock during the five days immediately prior to conversion. Based upon this formula, the lower the share price on the conversion date, the more shares the client would receive.
Although the Debenture prohibited Rhino's client from selling Sedona's stock short while the Debenture "remained issued and outstanding," Rhino allegedly engaged in extensive short selling on behalf of its client before the Debenture was converted. According to the SEC, that short selling increased the supply of shares in the market and depressed Sedona's stock price. Consequently, Rhino’s client received more shares when it converted the Debenture. Following the conversions, Rhino allegedly engineered the trades to conceal the client's involvement in the scheme.
Rather than contest the SEC’s charges, Rhino and Badian consented to the entry of an injunction for violation of the anti-fraud provisions of the federal securities laws, and agreed to pay a $1 million penalty.
Commenting on the case, Thomas Newkirk, Associate Director of the SEC’s Division of Enforcement, noted the potentially poisonous effect of death spiral financing, stating
Certain convertible securities, particularly those referred to as ‘toxic’ or ‘death spiral’ convertibles, present the temptation for persons holding the convertible securities to engage in manipulative short selling of the issuer's stock in order to receive more shares at the time of conversion.
The results can be disastrous for issuers and investors alike.
Regrettably, this is just one example.
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