What's worse is that often, discounted convertibles and Reg S placements become perfect vehicles for "shorting against the block"
Thus their shorts are pre-covered.
There was an article in Bloomberg magazine this spring about "Death Spiral" placements - who they work and the nasty effect on stock price. In all honesty, this is probably not quite total death spiral considering the fact that TRIBY is cash flow positive & the % of dilution is not going to be profound. And we don't know the agenda of who received the placement. They may actually hold some of the shares.
Here's some past SI posts about the subject. I was a holder of 2 of 3 of these companies, and it wasn't pretty. Bottom line is, issuence of discounted convertibles was probably an ill advised move on the part of a management who continue to act indifferent to the returns of their shareholders. When TRIBY dipped, I started watching since a re-entry at 1.75 was tempting. But then the declining volume got my attention. I will now definitely not be re-purchasing until I see the effect of the convertibles, and the # of shares each release. Any conversions since June will not show up in the next report, and those towards the end of the period will not be fully reflected since most companies reported "weighted" # shares.
Again, if the # outstanding shares does not exceed 25-26m by qtr 1 99, it will probably be safe to re-enter.
Honestly, if I was a current shareholder, I'd consider getting a motion for a moritorium on share placements including convertible placement AND granting new options on the agenda for the next annual meeting. Not that it would have a chance of succeeding, but it may sufficiently embasrrase the company into starting to do the right thing by their shareholders. Your money (probably dead money for a while at best) IMSCO Scott
exchange2000.com
exchange2000.com
Here's a post I saved a couple years ago. Since that thread no longer exists on SI, I can't verify what happened, but it probably was nasty too.
Rethinking Regulation S
by Louis Corrigan (RgeSeymour)
Imagine if a public company were allowed to issue shares on the sly, without telling its
shareholders
what it was up to. And let's say the firm issued millions of shares, offering them in a
private
placement at a 15% to 40% discount to the going market price, compensating one
class of
investors for potential risks even as others paid full price on the public market.
Now imagine what would happen if the folks who bought into the private placement
could turn
around and sell their shares on the open market before the rest of a company's
shareholders even
knew their stake had been diluted. The huge new supply of shares would hit the
market, the
stock's price would drop, and the average investor would be left virtually clueless
about what had
happened until is was way too late to act.
Not a pretty scenario. Yet it was a relatively common one until last October. That's
when the
Securities and Exchange Commission (SEC) enacted a new rule designed to stop
certain abuses of Regulation S, a section of the federal law that permits public
companies to sell unregistered
securities to overseas investors.
Now, just four months later, the SEC has issued proposals that present new obstacles
to the
unscrupulous investors and often questionable issuers that have preyed on the investing
public by
taking advantage of this safe harbor exemption from the SEC's basic public disclosure
requirements. Individual investors should once again tip their collective hats to SEC
Chairman
Arthur Levitt and his reform-minded sidekick Commissioner Steven Wallman.
Back in October, Levitt said that there were "pirates in this safe harbor." When the
new proposals
were issued on February 20th, he followed up on the theme. "Today, we launch a
regulatory
armada that should drive most of the marauders out."
In one respect, the SEC's recent and proposed revisions to Reg S represent the
triumph of rational
policy-making over the misleading one-world rhetoric that has often accompanied
efforts to make
global capital markets "free and open."
After it was adopted in 1990, Reg S was hailed by many experts in the field of
international
financial law as an important advance that would make it cheaper and easier for U.S.
companies to
raise money overseas. That's because they could now do so without having to comply
with "the
burdensome U.S. registration requirements," in the words of two commentators in the
journal
Euromoney. Other supporters, writing in the International Financial Law Review, hailed
Reg S
as "an enlightened and far-reaching accommodation by the SEC to the realities of the
growing
global market for securities."
What these supporters failed to consider is that the health of the U.S. financial markets
is
inextricably tied to the fact that the Securities Acts establish ground rules for public
companies that
are among the toughest in the world. The essential goal of those laws is to permit
capital formation
within the context of public disclosure of basic material information. It's hard to believe
that your
average reasonable investor would consider new share offerings immaterial.
Bending disclosure requirements simply to promote the presumed "free" flow of capital
essentially
damages the basic support for the whole system. That's because it's difficult to maintain
the
integrity of a system built on information when some private investors are allowed
special access to
information that can actually harm those investors who are kept in the dark. The best
way to
promote the efficient flow of capital, then, is to establish rational policies that mandate
equal
disclosure.
The SEC is not there yet. But the recent efforts to revamp Regulation S represent
important strides
to clean up what has become a real mess.
Prior to the October 1996 rule change, an issuing company could place shares with
overseas
investors without giving timely public notice that it was doing so. In many instances,
those shares
could be flipped back into the U.S. market after just 40 days, long before a company
submitted a
new filing to the SEC. Thus the shares often hit the market before most of the
company's public
shareholders even knew they existed.
Making matters worse, these "overseas" investors, who in some cases are simply U.S.
investors
operating through offshore shell companies, often hedge their investments by using
options or short
sales. That's especially true when the issuing company is a risky firm traded on the
Nasdaq
SmallCap market or on the OTC Bulletin Board. These companies often turn to Reg S
offerings
out of sheer desperation for cash to keep going. Indeed, some private placement firms
make their
living by proposing Reg S deals to such companies.
Given the risks, many of these deals can only get done if the shares are offered at a
deep discount
to the current market value. Thus offshore investors have often found themselves with a
near
sure-thing. With a stock trading at $10 a share, for example, they may be able to buy
into the Reg
S offering at $8 a share or less and short the stock at the same time. After 40 days,
and regardless
of how the stock fares on the open market, the investors can use the placement to
cover their short
position and simply walk away with an easy 25% profit.
Making matters even sweeter for such investors, some of these deals have been done
with
promissory notes. Investors could put virtually no money down until they actually sold
their shares.
What this meant, in effect, is that these "offshore" offering ultimately raised money via
the U.S.
market as the capital was actually coming from U.S. investors who bought the shares
once the 40
day holding period was over.
What the October 1996 ruling did was establish clear disclosure requirements
consistent with the
spirit of the U.S. security acts more generally. The rule required companies to report
other types of
private placements in their quarterly 10Q filings. The Commission deemed this
sufficient since
shares offered under Regulation D, for instance, are generally restricted for up to two
years and must be registered before they can be sold on the market.
That system, however, wasn't sufficient for Reg S offerings. The new rule required
companies to
report Reg S offerings on Form 8-K to be filed with the SEC within 15 days of the
sale of
securities. Buyers might still decide to flip their shares after 40 days, but other investors
would at
least be prepared.
Of course, this stopgap measure addressed only one of the relevant problems. As a
result, it may
have pushed issuers into employing even more dilutive Reg S offerings involving
convertible debentures. Such offerings can be structured in perfectly rational ways that
leave a fair degree of
risk in the deal for offshore investors. In the worse cases, however, they can seriously
dilute a
company's common stock. That's because the requirement for timely disclosure creates
a new
degree of risk for offshore investors, particularly if they expect hedging to be difficult.
That's
because other investors will know the dilution is coming, so the stock's value may drop
below even
a deeply discounted offer price.
Some convertible preferred stock offerings allow offshore investors to convert their
capital into
shares at a significant discount not to the current market price but to the closing price
on the day of
the conversion. What this means is that they are virtually assured a profit when they
decide to
convert. It also means they may have a powerful incentive to drive the stock price
down since their
set investment dollars can claim a bigger chunk of the company's ownership the lower
the stock
price gets.
A recent Reg S convertible preferred floated by the controversial SOLV-EX CORP.
(Nasdaq
SmallCap: SOLV) offers a case in point. The deal was structured so that offshore
investors could
convert their holdings into Solv-Ex stock at the lower of two figures: 20% above the
market price
on the day the deal closed (i.e. a purchase price of $14.25 per share) or 18% below
the average
closing price during the five days prior to conversion. One third of the preferred stock
could be
converted into common shares after 45 days, another third after 90 days, and the rest
after 105
days.
Most large sellers try to work their trades to get the best price for their shares. If
Solv-Ex shares
didn't immediately rise or show serious prospects for doing so, these Reg S investors in
Solv-Ex
actually had a powerful incentive to engage in sloppy selling to drive down the stock's
price. That's
because their cost basis gets lower as the stock falls.
The other rather sad corollary to such deals is that the potential share dilution is
unlimited: the
lower the stock price gets, the more shares that initial investment buys. Some
companies have even
found themselves in the bind of having too few shares authorized to cover such
conversions.
Others have simply refused to convert the preferred stock into common, claiming their
stock had
been manipulated by their Reg S investors.
Consider the case of STARTRONIX INTERNATIONAL (OTC Bulletin Board:
STNX). This
"leading provider of Internet-related products" is being sued by its own Reg S
investors. That's
because in early November, the company halted conversion of its privately convertible
preferred.
Company officials think their investors were actually manipulating the company's
shares. As
StarTronix chief executive Greg Gilbert told Dow Jones News in late December, "It
got so that we
could predict the day when a tranche [of securities] was coming in [to be converted]
because our
stock would drop 20%" just beforehand.
George Sandhu is an officer with Baytree Associates Inc., the New York-based
private placement
firm that has been doing Reg S deals since 1990. His company underwrote the deal for
StarTronix. He argues that this deal soured mainly because the company's
representations to his
firm "weren't exactly truthful."
He said StarTronix couldn't even meet the next week's payroll when Baytree came to
them. "You
tell me whether it's in the benefit of shareholders to rescue a company and give it some
life,"
Sandhu said. "I think it was in the benefit of them. And I don't think the company has
acted
correctly. The stock did not fall because of anything that investors did. I think on the
other side of
it, the company was trying to do other things besides really make this product work... I
think they
were more interested in where their stock was going than where their products were
going."
Sandhu said the that if you really looked at the trading pattern of StarTronix's stock,
there's no
basis to believe that the Reg S investors destroyed it. StarTronix attorney Ken Bloom
of Gartner & Bloom could not be reached for comment.
Sandhu added, however, that the proposed rule changes won't hurt Baytree's business.
"To us
Regulation S was just a way that made it simpler and easier to distribute stock to
overseas
investors.... Even without Regulation S, our business will continue." He said that the
company
usually works with mid-size companies and that the StarTronix deal was Baytree's first
private
placement for a firm listed on the OTC Bulletin Board.
He pointed out, though, that deals are structured based on the risks involved. "You can
structure
deals that don't incentivize the investor to take the stock down. When you're dealing
with
companies that are larger and of better quality, you usually structure a deal so that you
don't allow
that to happen." He said that restricting sales of Reg S securities to a year or more will
effectively increase the cost of capital for small companies that continue to do such
deals. "Now if someone's
got to hold for a year, an investor might ask for a larger discount or some other thing
that makes it
more cost-prohibitive to the small company."
Of course, one could argue that some companies don't merit further public financing
and that, in
any case, the rules for private placements under Regulation S ought to allow current
shareholders
to know what's going on if their equity is about to be diluted.
It's not clear whether the new SEC proposals will completely resolve all the problems
associated
with Reg S offerings even if they are passed in the present form. Indeed, the numerous
questions
posed by the Commission in the documents currently available for public comment
show the SEC
is anxious to close loopholes that lead to manipulation while at the same time making
sure that the
new rules are not unnecessarily onerous.
Still, the SEC seems prepared for real changes. The proposals call for eliminating the
recently
imposed rule that requires companies to file a Form 8-K within 15 days of a Reg S
offering.
Companies could now simply report that information in the quarterly 10-Q filing. But --
and this is
a huge improvement over the existing law -- the sale of equities offered under Reg S
could not be
resold into the U.S. market for at least one year, possibly two years.
That's because the Commission has proposed treating these Reg S equities like other
restricted
securities that fall under Rule 144 of the securities laws. The SEC has simultaneously
suggested
that the holding period for such securities should be dropped from two years to one
year. Under
this new proposal, then, the investment community will lose in terms of the timeliness of
disclosure,
but the longer holding period means the shares can't be almost immediately flipped into
the market.
The Commission will also place new restrictions on hedging activity associated with
Reg S
offerings, but it seems to believe that changing the holding period is the crucial element
in
discouraging speculation and market manipulation. "Maintaining a hedge for one or two
years, as
opposed to 40 days, is more costly and may be impossible for many of the illiquid
securities sold in
abusive cases," the proposal argues.
The new proposals also indicate that the use of promissory notes is inconsistent with
the intent of
Regulation S to allow companies to raise capital from overseas investors. But the
proposals remain
rather tentative both in regard to promissory notes and to the troubling issue of
convertible equities.
On the one hand, the Commission is "aware that many Regulation S abuses have
involved the use
of convertible or exchangeable securities or warrants." But as the proposal points out,
many
companies "legitimately offer under Regulation S either convertible or exchangeable
debt securities,
or warrants for common stock as a unit with other securities, to lower their costs of
capital."
J. William Hicks, securities law professor at Indiana University Law School in
Bloomington, thinks
the SEC is on the right track. Hicks literally wrote the book on Resales of Restricted
Securities,
and he has long been critical of the loopholes offered by Regulation S.
"I've been critical right from the beginning and actually recommended, as soon as there
was some
indication that there was going to be abuse, that they treat these [securities offered
under Reg S] as
restricted securities," he said. "When I made that recommendation in my book, I really
didn't think
that it was likely to be embraced just because the trend seemed to be in the opposite
direction,"
toward a market-driven system where the SEC would just step out of the way. "But I
think they've
suddenly realized that there are far more abuses than they anticipated and that the
seriousness of
these abuses are such that they need to be a little bit tougher."
Still, Hicks indicated that most of the cases involving Reg S that have been serious
enough to
attract government action or journalistic scrutiny involve more than mere registration
problems.
They involve violations of federal anti-fraud provisions of the securities law.
"So you've got a lot of misleading press releases that are blowing up the price back
home to
handle that influx of those securities," he said. "That, to me, is still going to remain a
problem. What
the SEC is doing with this is just removing one of the very strong incentives for taking
advantage of
this kind of loophole."
Hicks is optimistic that the proposed changes will help. He also said that he doesn't
think legitimate
companies will be hurt by the new requirements since qualified institutional investors
that
participate in the private offerings conducted by larger companies generally are making
long-term investments. Still, he's realistic.
"It seems to me that no matter how creative regulators are, and I think this was a very
creative
move on the part of the SEC to come up with Reg S... the creativity and imagination of
those that
don't want to follow the rules seems equal to it."
Though Rogue has often been critical of Barron's, it's clear that the weekly financial
paper has
done yeoman work in keeping up with those taking advantage of Regulation S. Jaye
Scholl and
other Barron's reporters have in the last year offered a number of first-rate exposes
into how some
companies and investors have abused this relatively arcane rule. The new SEC
proposal actually
cites these articles in footnotes.
One issue lurking at the edge of the proposed rule changes is the larger matter of
whether the SEC
is, even now, as sensitive to issues of corporate disclosure as it should be. With the
increased
access to online communications, the time may be ripe for investors to ask for all
private
placements to be accompanied by a contemporaneous notification from the issuing
company. Even
if the shares are restricted, don't all investors have a right to know when the companies
they own
plan to sell more shares?
The SEC is currently accepting comments on the proposed rule changes. Letters
should be
submitted in triplicate form to Jonathan G. Katz, Secretary, U.S. Securities and
Exchange
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. Online investors might
find it
easier to submit letters electronically to <rule-comments@sec.gov.> Comments sent
by e-mail will
be posted on the SEC's Web site.
--Louis Corrigan (RgeSeymour) |
