Alright Ken, you caught me. I rarely look at scans but I'm having a
difficult time finding new plays this weekend. HDIE comes up doing scans because of it has a fantastic anticipated growth rate.
The 3 Amigos have consistently avoided stocks that have finances involving convertibles (Reg S/ Reg D). Today's New York Times has an
article worth reading on this topic. Illinois Superconductor
and Geotek are two of the companies mentioned in the article.
The article can be accessed at www.nytimes.com (free membership).
<They call Peter Davis almost daily, strangers who say they want to help his Xoma Corp.
close the gaps in its finances. Many promise an immediate infusion of cash in exchange
for a certain kind of preferred stock.
But Davis, chief financial officer of the biotechnology company in Berkeley, Calif., says he is
on to their game. "We get calls from all over the place and try to steer away from these folks,"
he said.
As if fledgling high-technology companies didn't have enough problems, now they have to
worry about predatory investors who try to drive down the price of the shares they have
bought through high-volume short-selling -- that is, by selling borrowed shares, replacing
them later at a lower price and pocketing the difference.
These investors are able to turn the financial desperation of high-technology companies,
which often swim in red ink for years before developing marketable products, into big profits
for themselves at the expense of existing shareholders.
They do so by perverting a complicated financial transaction known as a
convertible-preferred-share placement. Such a transaction can legitimately serve as a lifeline to
promising but financially struggling businesses, advocates say.
Extremely rare only a few years ago, these deals now number in the hundreds annually,
according to analysts. But the companies that do them don't always understand the risks.
"Entrepreneurs who manage these companies are creatures of hope who always believe they
can make a profit on the cash from these financings," said Marcus Robbins, editor of the Red
Chip Review, a newsletter that covers small publicly traded companies. But, he added, they
"don't always know what they are getting involved with."
The transactions work this way: The company sells the investor a new issue of
convertible-preferred shares -- shares that have priority claims on dividends and assets and
can be converted to common shares -- through a private placement.
The placement includes a 1990s twist: Instead of the more usual practice of fixing ahead of time
how many common shares would be received, these preferred shares are convertible at a
floating ratio based on the stock price.
The lower the stock price happens to be when the investor decides to convert, the more shares
the investor would get. On top of that, the deals may include a discount of up to 30 percent,
giving the converting investor even more common stock in exchange for the preferred.
Firms that invest in such financings say they are a boon to innovative but cash-short
companies. "This is a huge industry involving many of the biggest investment banks on Wall
Street," said Mitchell Kaye, a principal of Brown Simpson Asset Management in New York. He
estimated that more than 1,000 deals worth several billion dollars will be concluded this year.
Even so, some people on Wall Street call such deals "junk equity." (Issues of debt securities
with similar conversion features are also growing more common, and pose similar risks.)
Robbins of Red Chip Review calls some of them "toxic convertibles" because they offer an
immense incentive for unscrupulous investors to drive down the share price by selling the
stock short. Generally, when a large number of short positions is taken in a thinly traded stock,
the price falls.
Such short-selling is illegal if used to manipulate the market for profit. And big profits are
clearly possible: Once the price is down, an investor can convert preferred shares for large
amounts of the company's common stock, use some to repay the borrowed shares, bank
profits from the short sale and own as many shares in the company as when he started, or
more.
To be sure, most investors in convertible preferred securities with such a protection against
falling share prices don't short the stock.
But whether or not short-selling occurs, shareholders upset at price declines that coincide with
such share conversions can react angrily. Last November, for example, shareholders of the
Illinois Superconductor Corp. in Mount Prospect, Ill., filed a lawsuit against the company's
managers and directors, accusing them of breaching their fiduciary responsibilities by
arranging a $15 million private placement of preferred convertible shares to Southbrook
International Investments Ltd. under terms that encouraged Southbrook to short Illinois
Superconductor's stock.
According to the lawsuit, Southbrook, which is based in the British Virgin Islands, or its
agents engaged in short sales to drive the price down and thereby collect more common shares
in return for preferred stock.
As a result, the share price fell from $12.375 to $11 within a few days last June, then from $9.75
to $7.625 within a similarly short span in August and finally dipped below $1 by December, the
complaint says.
One of the plaintiffs, the money manager Sheldon Drobny of North Brook, Ill., says he and his
investors took a $9 million hit as a result of the short-selling. He also claims that the operation
more than doubled the number of Illinois Superconductor shares, sharply watering down their
own shares' claim on future profits.
"Last year at this time, there were five million shares outstanding, but at this year's annual
meeting there were 12 million. That's a significant number," said Steven Shapiro, Drobny's
lawyer.
Edward Laves, Illinois Superconductor's chief executive, denied that he or his fellow managers
and directors acted irresponsibly. He characterized the lawsuit as retaliation for a suit the
company filed last spring against Drobny and other shareholders in a dispute over financing.
Laves added that the convertible placement was Illinois Superconductor's only financial option
after a failed secondary public offering. He said the company was now on the rebound, with
the stock now trading at around $2.75.
He attributed the share-price declines of last year to his company's disappointing results and
to general market trends, not to short-selling. "The market wasn't being nice to microcap
technology stocks," he said.
Illinois Superconductor, which commercializes high-temperature superconducting technology
for the wireless telecommunications industry, has raised about $50 million in private and public
offerings since it went public in 1993.
Southbrook, which was not named as a defendant, could not be reached to comment on the
accusations made in the lawsuit. Brown Simpson Asset Management, which participated in the
financing, declined to comment on the complaint or to provide information about Southbrook.
Whatever the merits of that case, predatory short-selling in conjunction with junk-equity
offerings appears to be on the rise. Gerald T. Kennedy, president of Kennedy Capital
Management in St. Louis, said his company had taken its lumps several times the last few
years.
"We've been hurt; we've been bruised," Kennedy said. "We actually had this happen in six
instances, and almost every time it's a disaster."
Kennedy sends companies in which his fund holds a position a letter, urging them to be on the
lookout for bad convertible preferred-stock deals. "We are bringing this scam to your attention
because we do not want to see companies in which we invest attacked by these vultures," he
warns them.
Because private placements need not be disclosed in advance under Securities and Exchange
Commission regulations, existing shareholders often have no idea what has hit them.
And when the financial transactions are spelled out weeks later in filings with the SEC, the
details are often so complex that an the average investor can easily overlook the danger.
Even deals in which no short-selling takes place can stir up trouble. For example, an investor in
Bio-Imaging Technologies, a medical-technology company in West Trenton, N.J., that recently
concluded a bitter battle over board membership, converted a large chunk of preferred shares
for as little as 63 cents, helping drive the stock price so low that NASDAQ threatened to delist
the company.
Another company, Geotek Communications Inc., a wireless communications company in
Montvale, N.J., has scattered its equity over so many financings that it was forced to
acknowledge in a recent SEC filing that it cannot calculate how many shares it might have to
issue to holders of preferred stock.
Ordinary stockholders who want to avoid being burned by market manipulators can take some
basic precautions: keeping track of new financings by companies in which they own shares
and getting out when a deal is announced on unfavorable terms.
The Diaz & Altschul Group, a New York firm that arranges and invests in convertible
financings, says it simply shuns deals that encourage investors to profit from a falling stock
price.
Arthur Altschul Jr., a founding partner, said companies could protect themselves against
short-sellers by avoiding deals that allow investors to convert preferred shares at a deep
discount to the market price; by insisting on the right to redeem an issue without onerous
penalties, and by demanding covenants against short-selling and pledges to comply with SEC
regulations.
Brian Pusch, a securities lawyer, says preferred stock that pays an automatic dividend is less
likely to come under attack by short-selling investors than stock that does not.
Other specialists counsel companies to limit the size of private placements and to put a ceiling
on the number of shares that may be obtained through conversion if the stock price falls.
But then again, companies worried about survival will often agree to just about any terms.
"What is implied is that a company is very high risk, and this is the only financing scheme
anybody is willing to provide funds for," says Robert Natale, a former investment analyst at
Standard & Poor's who is now with Bear, Stearns.
The SEC's guidance in junk-equity financing is a work in progress. The agency says it is eager
to stamp out "abusive practices." But just what qualifies as illegal stock manipulation depends
on the situation, says David Sirignano, associate director in the SEC's division of corporate
finance.
In any case, most junk-equity deals probably do more good than harm. "The role they are
playing is to fill the gap on high-risk technology," says James Donaghy, chief executive of
Sheldahl Inc., a computer technology company in Northfield, Minn., which has made several
private placements of convertible-preferred shares. Sure, he added, there is always the danger
that his company's stock will be shorted.
But, Donaghy said, "People just have to understand they are in that kind of business." > |
