"If 'Toxic Convertibles' Drive Up, Watch Out for Sinkholes"
By RICHARD KORMAN
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." |
