Death-Spiral Convertible Financier Has a Lot of Fun
BLOOMBERG BUSINESSWEEK
I frequently remind you not to take anything I say as legal advice, but I guess it's fine to take legal advice from this guy:
The financing technique is legal as long as the debts that are being paid off are real and the financier doesn’t kick any of the money from the stock sale back to the company, according to Mark Lefkowitz, another penny-stock financier who pleaded guilty in 2012 to breaking those rules. “The bottom line is, it’s supposed to be used for bona fide conversions of debt to equity,” says Lefkowitz, who’s cooperating with the FBI. He cut an interview off quickly, saying he was due to be sentenced soon and needed to check with his FBI handler before talking.
I mean, he should know what techniques are legal, right? Since he had to, like, hop off the call to go to prison for doing the other ones?
That's from Zeke Faux's amazing Bloomberg Businessweek story about Joshua Sason, a 27-year-old Long Islander who runs Magna Group, "which he describes as a global investment firm," though Faux describes it as "a pawnshop for penny stocks." Even outside of his financing techniques, Sason's life is shall we say colorful (lingerie-model girlfriend, high-school rock stardom, budding movie career, "plan to import sand from Israel and sell it as a collectible called 'Sand from the Holy Land'"). But here let's focus on the financing techniques.
Broadly speaking, the goal of these techniques is this:
A small troubled public company wants money.
All it has to exchange for that money is its own stock.
It is shall we say inconvenient for the company to do a regular underwritten public offering of its stock, because such an offering would require a lot of expensive and awkward disclosure of just how troubled the company is, or because it would be hard to find buyers for all that stock at once, or both.
And it is not legal for the company to just secretly sell stock into the market without doing a public offering.
So it decides to place the stock privately with a smart financing source.
It's not like the smart financing source wants the stock either! You don't get to be a smart financing source by buying penny stocks of troubled companies and holding onto them.
But "company sells stock to smart financier, who then sells it to the public" is not a good way to get around No. 4: The securities laws cover not only sales directly by companies to the public, but also sales by companies to the public by way of an "underwriter," and a financier who buys the stock only to sell it a minute later looks, to securities regulators, like an underwriter.
So you need to find a way to get stock into the financier's hands in a way that makes him comfortable he can get it out of his hands and into the hands of ... is it uncharitable to say "the unsuspecting public"?
Now I should pause here and say that this goal -- get stock from company to financier to public, get money from public to financier to company -- makes sense for the company (which gets money), and for the financier (who is well compensated for providing the financing), but is less obviously appealing to the public (who buys the risky stock without the disclosure of a public offering), and is very obviously not appealing at all to the Securities and Exchange Commission. The main point of the securities laws is to prevent companies from raising money from the unsuspecting public without registration and disclosure, so the SEC takes sort of a dim view of inventive efforts to do that. 1
So there is a long-running game in which penny-stock financiers find ways to get stock to the public, the SEC shuts them down, the financiers find new ways, etc. Here's a simple classic: The financier sells the company's stock short, selling X shares of stock into the market for $Y of proceeds. Then he gives the company $Z (Z << Y), the company gives him X shares of stock, and the financier closes out his short sale with the shares from the company. The financier is never long shares, and is never "really" short either, because he's arranged with the company to get shares to close out his short. So he's never at risk. This is a good trade, but also super illegal. 2
A variant on this classic uses convertible bonds. The company sells the financier a convertible bond in a private placement. The financier sells stock short, until he has sold enough shares to recoup his investment in the bond and make a profit. Then he converts the bond, gets the shares and closes out his short. Here the financier is at a bit more risk, because he does hold onto the convertible bond for at least a little while, and if the company goes bankrupt between the time that he gives it the money and the time that he finishes short selling and converts, he's out of luck. But he at least has a debt claim, and is never fully at risk on the stock. A nice thing about this approach is that this paragraph loosely describes convertible arbitrage, in which investors buy convertible bonds and hedge them by shorting stock. And that's totally legal, most of the time. But when it's clearly done with the intent of evading the securities laws -- with the intent of pumping out stock from company to public with only a fleeting stop-over chez the financier -- then it's not. It's a bit of a know-it-when-you-see-it kind of thing. 3
One bad sign is a "death spiral" convertible, one that converts into a fixed value rather than a fixed number of shares. Normal convertible arbitrage is practiced with bonds with fixed conversion rates. One $1,000 bond converts into, say, 50 shares, whatever the price of the stock ends up being, that sort of thing. But a $1,000 convertible bond that converts into $1,000 -- or, for that matter, $2,000 -- worth of stock, whatever the price of the stock ends up being, is a much more dangerous creature. For one thing, it tends to push down the stock price: The financier sells stock, the stock price drops, the financier is guaranteed more stock, so he sells more, etc. until the stock price gets near zero. 4 Also, though, when the financier is guaranteed a fixed amount of money, he's not taking any stock-price risk, and he looks a lot more like he's just transmitting shares from the company to the public. So buying a death-spiral convertible, shorting a lot of stock and then converting is very much frowned upon. 5
But that can be fixed! One apparently viable approach is to buy a death-spiral convertible, not short the stock, wait six months and then convert it. Six months is a mildly magical time period for the securities laws: If you buy a security in a private placement from a company and resell it to the public immediately, you tend to be considered an "underwriter" and get into trouble under step 7 in my list above. (The specific form of trouble that you get in, by the way, is "rescission liability": People who bought the stock from you get to sell it back to you at the price they paid, which, in a death spiral, could get ugly for you.) But if you buy the security in a private placement, wait six months and then sell to the public, you are generally not treated as an underwriter, and can sell freely. 6