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Shareholder backlash is building against “floating” or “floorless” convertibles, a type of so-called vulture capital financing that benefits an investment bank if a company’s share price drops. Public companies are increasingly resorting to lawsuits to nullify these agreements when their implications become clear. And individual shareholders are exploring their own legal options — both against investment banks and the executives who agree to the flawed financing — to compensate them for loss in shareholder value. Shareholders are also putting pressure on the Securities and Exchange Commission to require more stringent disclosures that could nullify the most harmful effects of these instruments. These financing instruments, often referred to as “toxic convertibles,” work as follows: Preferred shares are issued to investment banks that can be converted later into common stock at a discount to the prevailing market rate. Under the terms of many floating convertible financing agreements, the conversion can take place earlier and more shares can be converted if the company’s share price drops. Toxic convertibles are more commonly sold by smaller and less prominent investment banks, but larger institutions have also on occasion used them. Companies entering into these arrangements often find that their share price heads due south soon afterwards. The dilution resulting from conversion of large quantities of shares puts downward pressure on the share price, sometimes sending the stock into a death spiral. Some companies claim the devaluation of their share price is caused by more than just dilution, and they have taken the financing firms to court, alleging market manipulation. Two cases were settled in 1999 and early 2000, and another case is pending, against the same investment firm, New York-based Promethean Investment Group LLC, which has been charged (along with other firms) with conspiring to drive share prices down through short-selling. The first case, involving Intelect Communications Inc. of Richardson, Texas, alleged that Promethean and the other small firms, Angelo, Gordon & Co. LP and Citadel Investment Group LLC, pushed the price of Intelect stock down from $1.88 Feb. 24, 1999, to 66 cents per share April 21. During that same period, the short-interest position in Intelect stock shot up from less than 1.5 million shares to more than 3 million shares. After Intelect announced a moratorium on conversions of preferred shares, the price of the common stock rebounded to $1.97 within days — evidence, argued Intelect, that the price drop resulted from market manipulation by the firms. The case was settled unusually quickly — a month after the complaint was filed in June 1999. Under the terms of the settlement, Intelect issued a portion of the common stock claimed by the investment firms and cancelled the remainder of the preferred shares. The investment firms also agreed to a prohibition on involvement in short sales or other transactions through which they would benefit from a drop in Intelect shares, as well as agreeing to restrictions on the quantity of Intelect shares to be traded on any single day. The second case was filed by Ariad Pharmaceuticals Inc. of Cambridge, Mass., at the end of October 1999 against Promethean and a related company, HFTP Investment LLC. Ariad alleged that Promethean admitted to shorting 2.5 million shares of Ariad common stock — more than 10 percent of the total outstanding shares — and that the short-selling drove the Ariad stock price down from $1.81 June 2, 1999, to 56 cents by Oct. 11, 1999. Ariad charged that if Promethean continued to manipulate Ariad’s stock “like a yo-yo,” it stood to realize a 300 percent return on its investment within one year. The case was settled in January, shortly after Ariad submitted a request for all trades carried out by the investment firms through a New York brokerage, Cathay Financial LLC. In the settlement, Ariad agreed to convert 612 preferred shares into roughly 1.08 million shares of common stock, which Promethean then agreed to trade in the public market to cover its short position. In the most recent case, Log On America Inc. of Providence, R.I., alleges that Promethean, Citadel and Marshall Capital Management Inc., an affiliate of Credit Suisse First Boston, shorted Log On stock and drove the price from $17 per share in February down to $2.50 by Sept. 26. The price plunge made the firms eligible to purchase approximately half of Log On’s common stock. Marshall allegedly informed Log On that all of the investing firms held “massive” short positions in Log On stock. Court filings also list 12 other public companies in which Promethean and Citadel have allegedly engaged in similar market manipulation. Promethean released a statement describing Log On’s claims as “outrageous” and “the product of either reckless speculation or … deliberate malicious intent.” As shareholders are becoming more aware of the shortcomings of floating convertibles in relation to shareholder value, Promethean’s string of lawsuits has brought it under increasing investor scrutiny. In late August, executives of Nashville-based Shop At Home Inc. were quoted in The Tennessean saying that an increasing number of investors had expressed misgivings over a recently announced preferred stock arrangement with Promethean. “In the case of Promethean and certain other companies, you can’t see anything good in these deals,” says Aaron Brown, founder of New York-based eRaider.com, a mutual fund set up to unite shareholders against stock fraud and poor management. “There’s no protection written in, and the terms are so inequitable that you can hardly believe company management ever discussed them or even read them before signing.” Brown has been using Internet bulletin boards to rally investor pressure against toxic convertibles. “We’ve been accumulating the necessary data to show that these arrangements almost never work,” Brown said. “But there is a definite gradation of quality. Agreements involving Shoreline Financial Corp. in California are the best you can find, with the necessary safeguards and limits built in. Then you get the big investment banks like PaineWebber Inc., which are usually not the worst.” Brown believes there’s not enough money at stake in most of these cases to attract the contingency-based law firms that typically take on class actions, and inquiries with some leading class-action law firms indicate that, in fact, toxic convertibles have not yet appeared on their radars. But some lawyers who have conducted lawsuits against investment banks such as Promethean on behalf of public companies believe that in theory similar lawsuits could be brought by ordinary shareholders. “There would be a lot of technical hurdles, but if shareholders asked me to get involved, I’d look into it,” one attorney said. ERaider has targeted a toxic convertible signed by Transmedia Asia Pacific Inc. as a particularly egregious case. “It was a good business with good potential, but once it signed the agreement it lost 90 percent of its market cap,” Brown said. Transmedia presents an example of the difficulties faced by this kind of shareholder activism. Brown said he originally had the support of institutional shareholders, but many of them sold off their stock, and others went off and negotiated their own side deals. Worst of all, “The people who were scammed are blaming us for exposing it and driving the price down further,” he said. Brown says eRaider has decided to fight toxic convertibles in general in recognition of the difficulties of winning individual cases. The group has submitted proposals to the SEC to improve disclosure of toxic convertibles. An SEC spokesperson said at present floating convertibles do not need to be disclosed until the point where the investor wants to convert the preferred shares into common stock for resale. At that point, the full risks of the investment, including possible dilution and decline in share price, has to be disclosed in a prospectus. There is no requirement to outline these same risks to existing shareholders at the time the agreement is signed. The spokesperson declined to comment on the possibility of more stringent disclosure requirements in the future, but added, “It’s a priority for us to look at ways to make investors more aware of risks in investing.” The National Association of Securities Dealers Inc. calls for disclosure and shareholder approval for what it terms “Future Priced Securities,” but shareholder approval is not necessary if the agreement caps conversion of the security at 20 percent of the common stock, or if a floor is placed on the conversion price. The 20 percent cap is easily evaded if conversion is made in stages, and if the floor of the conversion price is low enough, shareholders can still suffer significant depreciation of their holdings. At the same time, any prudent reader of the NASD rules can detect a strongly cautionary note toward this type of financing: “[T]he issuance of Future Priced Securities may be followed by a decline in the common stock price, creating additional dilution to the existing holders of the common stock.” But Brown believes the NASD rules do little to protect shareholder interest. “Threatening to delist the company makes things even worse for shareholders,” he said. Copyright (c)2000 TDD, LLC. All rights reserved.

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