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Beware of Companies that Accept "Toxic Convert" Financing
hey are called "toxic converts", "corporate loan-sharking", "payday advances", "pawnshops for dot coms" and "death spiral deals". By whatever name, they nearly always are toxic not only to the company obtaining the "financing", but also to the unsuspecting investors who own the publicly traded stock in the company.
As reported in the April 1, 2001 issue of
Red Herring (
"Death by Finance"),
struggling companies (mostly dot coms) burning through cash no longer can turn to the IPO or secondary markets for additional funds. As a result, and rather than closing their doors, these companies are accepting so-called PIPE deals - private investment in public equity.
The pace has accelerated and likely will continue to accelerate. Six years ago, there only were 36 death spiral deals worth a combined $264 million. In 2000, 220 companies accounted for $2 billion of these deals. Of the 220 companies that agreed to toxic convert deals in 2000, only 5 companies have ended up in better shape. Most of them tanked, according to Red Herring. Companies such as CMGI, eToys, Efax, Intraware, MicroStrategy, Ramtron, ProxyMed and Ariad all fared badly.
One lawsuit describes the deal this way: "An unlawful scheme to short sell [company] stock in sufficient volume to drive down its price, knowing that [the private investors] would be in a position to cover the short sales by converting their preferred stock at depressed market prices". The centerpiece of the deal is the explicit right given to the private investors to short sell the very company that they have financed. To understand why, Red Herring provides the following "anatomy of a toxic PIPE deal":
An inchoate company goes public.
The company burns through its IPO capital and desperately needs more.
With profitability a distant and flickering hope, traditional capital markets snub the company's entreaties for cash.
Private equity firms offer infuse cash, but receive death spiral convertibles, obtain steep discounts (as high as30%) on common stock purchases, and reserve the right to short sell the stock of the company.
For their cash infusion, the private investors receive preferred stock that can be converted to the discounted common stock, usually within 90 days. Notably, there is no "floor" on this provision, such that the more that the price of the stock drops, the more common stock the company must issue to satisfy its obligation to the private investors.
The private investors begin to short sell the company's stock. As the stock price falls, their ownership stake increases.
Others, such as professional short sellers and individual investors, spooked by a volume increase in the thinly traded stock, jump on the selling bandwagon, thereby driving down the price of the stock even further.
The stock hits $5 per share, triggering institutional investors to sell and brokerages to stop research coverage.
The stock continues to plummet, and delisting appears inevitable.
The company converts the private investors' preferred stock into common stock at the current market rate, less an agreed upon discount of between 20% and 30%.
The private investors use newly converted common stock to cover their short positions, earning handsome profits.
The private investors sell off any remaining common stock that they hold, or hold the shares for the inevitable liquidation or takeover.
In some cases, the private investors end up with enough stock to hold a majority position in the company!
The private equity firms reportedly doing most of these PIPE deals are: Promethean Asset Management, the Citadel Investment Group, Marshall Capital Management (a subsidiary of Credit Suisse First Boston), and Angelo, Gordon & Company. Those firms are assured a profit, according to Red Herring, because they receive company stock discounted below the market price, and because shorting these companies nearly always is a good bet in view of their poor performance.
One company, Log On America, has decided to fight back. In typical fashion, the company's stock price plummeted as the private investors reaped the benefits of short selling and share conversion. However, Log On America has sued the private investors for securities fraud. The private investors defend by claiming that Log On America simply is reneging on the terms of the deal and there is nothing inherently illegal in short selling stock. Additionally, Log On America has sued Credit Suisse First Boston. Turns out that when Log On America sought financing advice from Credit Suisse First Boston, it advised the company to contract with its own subsidiary, PIPE deal firm Marshall Capital Management.
Investors owning publicly traded stock in a company should not always be pleased with news that the company has secured additional financing. Remember, "The devil is in the details".
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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is the immediate past co-chair of the Chicago Bar Association's Securities Law Committee, the immediate past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He can be reached at 312-641-2929. The firm's website, www.FinancialCounsel.com, contains global market intelligence, daily financial news, alerts, articles, studies, a calendar of upcoming seminars and events, portfolio "diagnostics" tools and book recommendations.
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