EDIT: This article which was published by a prestigious securities law firm, clearly describes the death spiral financing strategy, their structure and likely fallout. If you look at the ASR convertible debentures and their attendant SEC filings, I believe you will see a direct parallel.
Copyright @2008 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com ¦ 1
CLOGGING THE PIPES: THE SEC CRACKS DOWN ON "DEATH SPIRAL" CONVERTIBLES
By John P. Cleary, Esq.
Procopio, Cory, Hargreaves & Savitch LLP
PIPE is an acronym for a private
investment in public equity. In a PIPE,
a publicly traded company issues
securities with a commitment to
register the securities for resale
promptly upon closing the
transaction. The Securities and
Exchange Commission (SEC) has
permitted PIPE transactions through
Rule 152 under the Securities Act of
1933, as amended, which provides a
safe harbor for issuers completing
private placement offerings and
subsequently registering the
securities for resale to the public.
Typically, the SEC raises no objection
when securities are privately placed
with the closing of the transaction
contingent on the filing or
effectiveness of a resale registration
statement as long as (a) the
purchasers in the private placement
are irrevocably bound to purchase the
securities subject only to the filing or
effectiveness of the registration
statement, and (b) the purchase price
is established at the time of the
private placement. These are known
as "traditional" PIPEs. Traditional
PIPEs typically attract long terminvestors
who are betting on the
performance of the company and its
stock price.
In recent years, non-traditional, or
"structured" PIPEs have evolved in
which the first-step private placement
involves the sale of debt securities
that are convertible into common
stock at a conversion price that
automatically adjusts downward if the
company’s share price falls below the
initial conversion price. Unlike
traditional PIPEs, the purchase price
is not set at the time of
the private placement and the
debenture is convertible for a fixed
dollar amount rather than a specific
number of shares. These have been
colloquially dubbed "toxic" or "deathspiral"
convertibles, and have drawn
the intense scrutiny of the SEC.
The Mechanics of a "Death-Spiral"
When there is no limit on the
downward adjustment of the
conversion price, the prospect of
large-scale conversions and sales at
declining prices can create selling
pressure which pushes the issuer’s
share price downward. Structured
PIPE investors are ambivalent
towards the performance of the
company because they can reap
substantial gains as the stock spirals
downward.
To illustrate the strategy, an investor
will short sell the company's stock at a
price of "X" per share. A high volume
of short selling pushes the share price
down to X-1. The investor’s
conversion price is then reset to the
discounted X-1. The investor then
partially converts the debenture at X-
1 to cover the shares it sold at X,
delivers the shares necessary to cover
the short sales and has a large number
of shares left over, which it can then
sell when the price hits X-2. The more
the investor pushes down the market
price with this strategy, the more
profit it makes on each conversion. If
the investor short sells at X per share,
it will make much more if it can
convert its shares to cover at X-4 than
it will make by covering at X-2. The
"death spiral" continues until the
company is forced to issue huge
amounts of virtually worthless stock.
The investor already locked in its
profit with short sales while the
ordinary shareholders get crushed.
The SEC Acts to Curb PIPE Abuses
To give PIPE investors the liquidity of
marketable securities, after the
closing the issuer has to register
resales of the PIPE shares through a
Rule 415 shelf registration. Starting
about a year ago, many issuers began
receiving SEC comments on their
resale registration statements
questioning whether they were
eligible to register resales of the PIPE
shares. The SEC was taking the
position that the issuers receiving the
new Rule 415 comment were seeking
to register so many shares that their
PIPE transaction should be treated as
a primary offering rather than a
private placement followed by
separate secondary distributions by
the PIPE investors.
The SEC – through its staff in public
speaking engagements – recently has
cautioned that comments should be
expected when an issuer registers for
resale more than one-third of its
outstanding shares held by nonaffiliates.
Because the number of
conversion shares is virtually
unlimited in structured PIPE
transactions, the SEC’s action is, for
the most part, directed toward the
abuses of "death spiral" convertibles.
As a result of the SEC’s stance on Rule
415, most "death spiral" convertibles
have either been converted to
traditional PIPEs or aborted.
It appears that issuers engaged in
JULY 2008
JOHN P. CLEARY
Copyright @2008 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com ¦ 2
traditional PIPE transactions selling
securities at fixed prices should
continue to be able to rely on the
SEC’s historical position in PIPE
transactions, particularly if the
amount of securities sold is relatively
small in relation to the public float.
Convertible Debt in Microcap
Financings
Although the SEC’s recent action to
protect microcap issuers has helped
curb abuses, issuers still must be
vigilant against predatory investors
seeking convertible debt instruments.
Typically, PIPE transactions impose
upon the issuer a contractual
commitment to file a resale
registration statement and use its best
efforts to have it declared effective by
the SEC. More often than not, the
issuer is subject to cash penalties if
the SEC does not declare the resale
registration statement effective within
a stated time period. As a result of
these provisions, PIPE investors who
have their liquidity blocked by the
SEC are able to effectively rescind
their investment through the
liquidation clause.
No matter what the SEC’s position,
issuers should avoid structured PIPEs
at all costs and maintain some control
over dilution by insisting on limits on
adjustments in conversion rates and
liquidated damages. "Death spiral"
convertible debentures are, in most
cases, the kiss of death when it comes
to financing for a company seeking to
raise capital.
Mr. Cleary is an attorney with Procopio,
Cory, Hargreaves & Savitch LLP.
Reach him at 619.515.3221 or
jpc@procopio.com.
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