Deepa Nayini, the Toxic Convertible: Establishing Manipulation in the Wake of Short Sales

• Publication year: 2005

THE TOXIC CONVERTIBLE: ESTABLISHING MANIPULATION IN THE WAKE OF SHORT SALES

INTRODUCTION

The recent collapse of the NASDAQ market has left many newly public companies still in their development stage hoping that the long dormant public offerings market will soon awaken. Many of these fledgling companies are in dire need of additional capital but have few options in the wake of the recent economic downturn. Some have resorted to a new species of financing, called the toxic convertible, to raise capital in the absence of alternative options. Companies that turn to the toxic convertible are usually in financial trouble and are hoping for short-term aid.¹While this kind of financing is a boon for some, the toxic convertible is often the final nail in the coffin for troubled companies.²Recently, there have been a number of cases in which companies using toxic convertibles have alleged that investors backing this type of financing engaged in market manipulation to the detriment of the company and the investing public.

Two of the most important provisions in the U.S. Securities and Exchange

Commission ("SEC") arsenal for policing toxic convertibles³are Sec. 9⁴and

Sec. 10(b)⁵of the Securities Exchange Act of 1934. Both provisions target manipulative practices and may be useful in litigation against investors that use short selling to manipulate the market while involved in toxic convertible financing.

Because the use of toxic convertibles to raise capital is a recent phenomenon, there has been little case law related to how securities laws regulate the behavior of parties involved in the financing. Consequently, companies who allege manipulation under either Sec. 9 or Sec. 10(b) have almost no guidance as to how to prove their claims. This Comment addresses how a company can employ both Sec. 9 and Sec. 10(b) to prove market manipulation when investors abuse toxic convertible financing.

Part I defines a toxic convertible and explains how an investor who buys a toxic convertible can manipulate the market for the underlying stock by aggressively selling the stock short. Part II discusses the history and purpose of the 1934 Act. Part III focuses on Sec. 9 of the 1934 Act and explains how it could be a legitimate tool to police market manipulation against unscrupulous toxic convertible financiers. Finally, Part IV examines the history, purpose, and the potential use of Sec. 10(b) and Rule 10b-5 of the 1934 Act in toxic convertible manipulation claims.

I. CONVERTIBLE FINANCING

Not all publicly traded companies have the ability to raise capital through traditional methods of financing such as secondary public offerings or loans from investment or commercial banks. In lieu of these traditional methods, companies frequently turn to alternative financing structures. Some of these alternative structures involve obtaining capital from venture capitalists, who are key players in financing high risk ventures.⁶

A. Standard Convertible Preferred Financing

One type of financing structure, convertible preferred financing, entails issuing preferred securities⁷to venture capitalists in exchange for capital.⁸A common characteristic of convertible preferred stock⁹is the stockholder's ability to convert the preferred stock into common stock.¹⁰Companies employ two methods to determine how many new shares they must issue to complete a conversion of the preferred stock. When the convertible security financing employs a fixed ratio for the conversion, then the company must convert the convertible security into common stock based on a fixed price.¹¹If the conversion ratio is based on fluctuating market prices, then the amount of common stock the company issues to the convertible security holder depends on the price of the stock at the time of the conversion request.¹²

B. Antidilution Provisions

Once a company has issued a convertible security, it retains the ability to dilute the value of that conversion feature. Dilution of the conversion feature results in a transfer of wealth from the convertible security holders to holders of common stock.¹³However, convertible security buyers are not without protection. Antidilution provisions, included in modern convertible securities or in the charter or indenture creating them, protect the amount and character of the underlying security received in a conversion.¹⁴Typically, venture capitalists demand the protection afforded by these antidilution provisions.¹⁵

Conventional antidilution provisions come in two forms: the "full-ratchet" provision and the "weighted average" provision.¹⁶A full-ratchet provision provides that if a company issues one share of stock at a lower price or the option to purchase the stock at a lower aggregate price, the conversion price of the preferred stock decreases, or "ratchets down," to the lower price.¹⁷The decrease in the conversion price occurs regardless of the number of shares of stock the company issues at the lower price.¹⁸A weighted average provision also reduces the conversion price of preferred stock but takes into account how many shares or rights the company issues in the dilutive financing.¹⁹Hence, if a company issues only one or two new shares of stock, the conversion price will not decrease much, but if a company issues many shares, the conversion price will decrease greatly.²⁰Consequently, a weighted average antidilution provision is less punishing than a full-ratchet provision. Both full-ratchet and weighted average provisions can be powerful tools in the hands of venture capitalists, ensuring their percentage of a company's stock is not overly diluted.

C. Toxic Convertible Financing

Less conventional convertible security financing structures utilize a conversion ratio that is based on fluctuating market prices.²¹Hence, a company will know how many shares of stock to issue only when the convertible security holder requests a conversion. In addition, if the price of the underlying stock decreases, the company has to issue more stock to the holder of the preferred securities if there is a conversion request.²²Deals that use conversion ratios based on fluctuating market prices and that do not have a price floor are commonly referred to as toxic convertibles within the industry.²³Because the convertible security holder benefits²⁴when the stock price drops, toxic convertibles present a major opportunity for abuse.²⁵Thus, many companies enter into toxic convertible financing deals to raise capital only as a last resort.²⁶

D. Toxic Convertibles and Short Selling

One common abuse of toxic convertibles occurs when the holder of a convertible preferred security sells the company's shares short in the hope of driving down the stock price.²⁷A short sale is the "sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller."²⁸Typically, the short- seller borrows stock from a broker-dealer to deliver to the purchaser and then closes out his position by purchasing replacement stock on the open market to return to the broker-dealer.²⁹

An investor sells short when the investor believes that the price of the stock will decrease.³⁰If the stock price decreases, the short-seller will profit by keeping the difference between the value of the shares borrowed from the broker-dealer and the cost of the shares purchased on the open market after the stock price decreased.³¹If the price of the stock eventually declines to zero because the stock becomes worthless, the investor will not have to purchase the stock on the open market to close out his position, and the investor gets all his money out in cash.³²

Short-selling serves two important purposes in the market: It improves the efficiency of securities pricing, and it increases liquidity.³³Conversely, short- selling can have a negative impact on the market. A large increase in the short interest in a stock can create the impression in the market that the stock is overvalued or, more damagingly, that there is something wrong with the company.³⁴When this occurs, investors who own the stock will be persuaded to sell, and potential purchasers will be dissuaded from buying because of the implicit message a large short interest in the stock conveys to the market.³⁵

Consequently, the price of the stock will drop. If there is a subsequent increase in the number of short orders of the stock, the cycle will continue, creating a downward spiral in the price of the stock. This problem is even more pervasive when the stock is not heavily traded because price adjustments in a thin market are more abrupt than in a robust one.³⁶Hence, when an investor sells a large number of shares short, the price of a thinly traded stock will decrease more sharply than that of a heavily traded stock.

The implications of selling a stock short are evident in the context of a toxic convertible deal. If the holders of a convertible security sell enough shares of the underlying stock short, the price of the underlying stock will decrease. The convertible security holder's conversion price is then reset to the new price of the stock.³⁷The convertible security holder can then issue a conversion notice to the issuing company at the lower conversion price to cover the short order, deliver the stock necessary to cover the short order at a lower price, and keep the difference as profit.³⁸The lower the price of the stock, the more money the convertible security holder can earn from selling short and converting his preferred stock into common stock, and the more shares the company has to issue to him.³⁹

The hallmark of the toxic convertible is the convertible security holder's ability to bypass market forces. The convertible security holder is selling the stock short in the public market, driving the price down, but obtaining the stock to cover his short sale in a private transaction, thereby avoiding placing any upward pressure on the price of the stock.⁴⁰This opportunity to...