e.Digital Corporation (fka EDIG)

[Cassandra]

"In reality, E-Digital probably had no other choice than to raise money using this vehicle."

I believe your scenario is pretty close to reality. However, the fact that it was the only option available to raise money does not change the fact that the Series D and E financing vehicles are indeed the dreaded toxic convertibles that usually cause a dramatic drop in share price as the financiers short before covering with below-market conversion shares.

The following article is an excellent discussion about this kind of financing vehicle:

Toxic (Death Spiral) Convertibles

In many ways, the issuance of toxic convertibles are a legal method to transfer assets from the existing common shareholders into the pockets of the toxic convertibles and, to a smaller degree, the management. The toxic convertible holders get the bulk of the benefit, but don't be fooled - the issuing company's management is also a beneficiary. Let's face it, most of the companies that stoop low enough to issue these death ride convertibles do it because without the quick cash they bring in the Company would be forced to go out of business. In almost every case, the small amount of cash they receive is not enough to rescue the business which is almost always a casualty of bad business decisions our faulty business plan capped off by the terminal decision to issue the death ride convertibles. The small amount of cash and brief window of time afforded by the convertible's issuance is almost never enough to rescue a company which by all rights is already on life support. In the meantime, management gets to draw what is usually generous salary and benefits for awhile longer and may even bail out of their own share positions before the ship sinks entirely.

While the only winners in the issuance of death rides is the convertible holders and the management, there are lots of losers on the deals. The biggest losers are usually the company's original creditors. If we assume that most of the issuing companies are destined for business oblivion anyway, then certainly the company should end its life while there are still assets left to pay off existing debts. After the death ride is over, there is usually nothing left and the creditors are left with nothing. That money is almost always siphoned off into the pockets of the toxic convertible holders who almost always short the issuing company right into the ground. The common shareholders are also losers. Like the creditor scenario, any possible assets that might be available to the common shareholders end up in the pockets of the convertible holders. However, smart and attentive common stockholders should be able to recognize a toxic convertible deal and bail out of the stock before the death spiral begins, assuming, of course, that they have adequate warning of such a pending deal. Unfortunately, most companies do not inform their common shareholders of such deals until long after the deal has been struck and the toxics issued. There is no regulatory requirement that issuing companies must warn their shareholders of such deals beyond their regular SEC filings, particularly if the issuing company's shares are traded on the OTCBB or the Pink Sheets. Therefore, I have seen cases where a company issues toxics immediately after they complete their regular filing and shareholders are in the dark until their next one, which could be anywhere from 3 to 5 months down the road. By then, the stock price might have already cratered. The same is true of Regulation S stock sales which are also often done without the knowledge of the existing common shareholders. By the time they found out, the holding period has expired and the share resold into the US market for a quick (and usually very large) profit.

If management understands what happens with "Death Rides", then why do they sell them in the first place?

One of the scenarios could be that the management and Board of Directors really, truly thinks the little money raised through a toxic convertible will be enough to save the Company. You could call this the "prettiest baby syndrome" where the management thinks that their company is such a good investment that the toxic buyer won't want to short the stock but instead hold the common shares through conversion. Unfortunately, I realistically have seen almost no cases where I think this scenario could actually be the case. The likely outcome of any toxic issue is almost completly intuitive. If, for some reason, a company officer or director doesn't know what will happen the minute they issue one, they could spend 5 minutes checking the history of these instruments and find out.

If the management of an issuing company truly and genuinely believed without a doubt that the issuance of toxic convertibles was the company's only hope to succeed in business, then I have a few suggestions. First, company management should agree to accept no salary or benefits until the convertibles are extinguished. After all, they believe the money provided by the sale of the toxic convertibles will help the company succeed. If so, then by forgoing the benefits and salary the company can use the money saved and become successful that much sooner! Company management should also "lock-up" every share, warrant and option they hold, directly and indirectly, to prevent them from cashing in until the convertibles are extinguished. Again, if they really believe that money will put the company on the long-term path to success, they should be thrilled to wait and hold every share they own until after the selling pressure from the toxics are gone, the company is on sound footing and the stock price will be higher. Hey, locking up management shares will pay off for them down the road, right? Finally, if management is so sold on the deal, they will have no qualms about informing existing shareholders of the terms before the deal is done. If they are that confident that selling toxic convertibles is a good deal for all shareholders, then management should be ecstatic about getting the opportunity to inform shareholders just how good a deal it is, right? And, since it is the existing shareholders that will be most effected by the toxic issuances, let them vote on it first. Of course, I have yet to see the management from an issuing company do many of the above, let alone all off them.

To no one's surprise, the management of many of the companies which perish after issuing these toxic convertibles blame the buyers for "killing" the companies through the fully hedged shorting of the common shares against the discounted convertible shares. They claim they had no idea that their stock would be shorted to oblivion. Unfortunately, this is highly unlikely. Most of the buyers of these toxic convertibles have very long track records, bought lots of previous toxic convertible issues and almost without exception the share prices of the issuing companies approach zero shortly after the buyers get their hands on the security. It doesn't take a genius to figure out the buyers are not losing money even though the stock tanks. Additionally, shorting against a convertible debenture is not illegal, nor is it "naked shorting". It is, in fact, "Covered" shorting and in most cases is allowed by market regulations, regardless of what the ignorant internet chat room and discussion board posters claim.

The outcome of these deals is well known and, frankly, a no brainer. The management of the issuers are giving the convertible buyers a license to take shareholder money. It is very clear that the management of the companies issuing these floorless "Death Ride" convertibles DO know exactly what is going to happen. Even though they want you to think they are after the fact, they really are not that stupid. If you read the SEC filings related to the registration of the common stock reserved for the conversion of the floorless convertibles you will almost always see under "Risk Factors" a complete discussion of the "death spiral" and what it is likely to do to the company and the price of its stock. In other words, their regulatory filings clearly state that it is likely that the common stock will be shorted into the ground. Considering that the officers and directors have signed these documents, I think they know right away what is going to happen to their shares. Management knows very well that they are likely committing suicide for the company when they issue them, but they do it anyway.

So what does all this mean? The answer is simple - selling toxic convertibles is NOT in any way good for shareholders or creditors. In essence, it is like putting a dying company on temporary life support and making shareholders pay for it, usually without their knowledge or consent. If you are management of a Company and you are stupid enough - yes, STUPID - to sell a toxic convertible, you should be striped naked and paraded up and down the streets with a sign around you neck that says "I stole all my shareholders's money". And, if you think you aren't stupid but you sell a toxic convertible anyway, then you are GREEDY. Yes, greedy. The only explanation (if not stupidity) is that you wanted to milk the company for a little more money, either in salary, or benefits or personal stock sales, all the while you are selling your shareholders down the river to the toxic convertible buyers who are shorting your stock into oblivion.

As the regulations are now, I see absolutely no economic benefit for allowing the existence of toxic convertibles. None. For whatever reason, there has been no real call by shareholder groups to eliminate toxic convertible sales. Considering that many of the most active and best known hedge funds which buy these deals are connected to some of the largest financial firms in North America, I would imagine that any move to do so would be bitterly fought by these financial powerhouses. Buying a toxic convertible is like shooting fish in a barrel. It is almost impossible not to make lots of money on the deal which explains why there are now so many hedge funds looking to invest in discounted share deals be it either toxic converts or Regulation S stock sales. Unfortunately, there seems to be no shortage of ignorant investors willing to buy the converted common shares all the way down, either. If the victimized shareholders wake up and stop aiding and abetting the convertible sellers, it might remove much of the financial incentive for the buyers and management of the selling companies and reduce the amount of toxic convertible sales over time. So far, though, I find that highly unlikely. As long as the practice continues, the best thing an investor can do is not to buy any company that has issued a toxic convertible and don't become a victim.

Toxic Convertibles are not the only ways that some companies are able to issue discounted shares. There are also Regulation S sales and "Consultant" shares, both of which have been immensely popular among stock fraudsters. By no means all Reg S and Consultant share issuances are fraudulent, but unfortunately it is not uncommon. More on those forms of issuances coming up.

Source: http://www.taylorstock.com/page7.html