The Securities and Exchange Commission

[thepennyking]

Naked Shorts on Earth

Published: 3/23/2004 by Tastes Like Chicken

Greetings, cuz!

No, I have no pictures of Martha behind bars, and I am shocked that you would even want to see such a thing!

Yes, I know what a floorless convertible is.

No it is not a rusted out 1958 Chevrolet that covers you with water from under the dashboard if you drive through a puddle.

Once again, these stock market people have their own little language. I think they obfuscate things on purpose, but hey, what do I know?

Grab a snack and relax, and let’s start at the beginning.

Don’t skip over any of this, OK? Your girlfriend gets naked somewhere in the middle, and you don’t want to miss that, right?

A “floorless convertible” is a kind of bond.

A bond is a “note” or “debt instrument” issued by a company in exchange for money.

The company borrows money from the person they issue the bond to, in exchange for a promise to pay that money back, usually with interest.

Yes, it’s just like an “IOU”. The company owes the bondholder money.

The purchaser of the bond receives principal or interest payments (or both). Some bonds are “secured” by assets of the company, and some are not.

A secured bond allows the holder of that bond to lay claim to the assets of the company if the company fails to meet its obligation to pay the promised principal or interest on the bond.

A debenture is an unsecured bond.

Unlike a secured bond, a debenture is not secured by company assets, and the holder is not entitled to claim any assets of the company if the company defaults on the note.

One particular debenture has a very creative feature attached to it.

A convertible debenture means the bond can be changed, or “converted” from one form to another form. The most common form of change is conversion into common stock.

There are advantages and disadvantages to the company when it issues a convertible debenture. Advantages include the ability to raise money without issuing additional stock (thus avoiding immediate dilution of the stockholder’s earnings per share), and the ability to issue the debenture at a lower interest rate than another form of bond, because the purchaser will accept a lower interest rate for the privilege of converting the debenture into common stock at some point in the future.

Disadvantages to the company include a higher taxable income, dilution of stockholder earnings, and a potential shift in specific shareholder’s control of stock (and their control of the company) when the conversion takes place.
Conversion takes place according to the “conversion ratio”; debenture value X is converted into Y shares of common stock.

The number of shares to be received in the conversion is governed by a formula. Usually, the convertible security is exchanged for common stock of the issuer at the holder's request by dividing the face value of the debenture by a market price of the common stock that is discounted at the time of the conversion.

Now to the specific convertible debenture you asked about:

A floorless convertible debenture has a “floating” exchange rate built into the conversion agreement. The conversion rate (number of shares the debenture can be converted into) is “adjusted” to convert to more shares acquired (per dollar of investment) in the event the price of the stock goes down between the time the debenture is issued and the time when it is converted into stock. The lower the stock price goes, the more shares the holder of the debenture gets for his or her note.

It’s called “floorless” because there is no “bottom” to the lower price of the stock. Stocks can turn out to be worthless, as we all know.

Well, most of us, anyway.

Here’s a very simplified example of how a “floorless” conversion might work:

Nifty Alien Reptiles from Flamfoozie (ticker symbol NARF) issues a floorless convertible debenture with an interest rate of 2% simple interest per year to your sweetheart, Snookiepoo.

On April 1, 2004, the stock of NARF is trading at 1000 Intergalactic Credits per share. On April 1, 2004, Snookiepoo gives the company 1000 Intergalactic Credits in exchange for a piece of paper that says the company will pay her 2% interest (for example) every year for five years. At any time in those five years, Snookiepoo has the right to convert her little piece of paper into one share of stock in NARF.

Additionally, written into this particular note (the floorless convertible debenture) is a clause that says something like,

“If any time in the next five years the stock price is less than 1000 credits per share, and if Snookiepoo decides to exercise her option to convert her note into stock at that same time, then Snookiepoo gets more than one share of NARF (as calculated by the conversion ratio written into the note) when she converts her debenture into shares of stock. In fact, whatever the price is, if it is less than what it is now, she not only gets more than one share, and she not only gets all the stock she would expect to get at that future price, she gets to figure in a additional discount per share of the then-existing stock price when she converts.”

Fast forward…and the stock gets crushed.

Shocking, yes?

On December 25th, 2005, Snookiepoo decides to convert her note to stock. On that day, the stock is trading at 10 (for example). With the conversion rate in the note as her guide, and the discount she gets, she is allowed to convert her note into more than 100 shares of stock.

Sounds like a good deal for Snookiepoo, eh? It is.

But what if (and I say this with all due respect) Snookiepoo wanted to take advantage of the situation? In that case, the company that issued the floorless convertible debenture has a little problem.

Let’s say Snookiepoo happened to be an unscrupulous and very greedy individual with some extra cash to toss at a risky and unsecured bond issued by a company that for some reason couldn’t obtain conventional financing.

Let’s further say that Snookiepoo could short that same company’s stock without actually borrowing it.

Nobody who owns NARF stock and wants it to go higher would want to loan it out in order for it to be shorted, but Snookiepoo doesn’t worry about borrowing the stock.

She just sells it short without borrowing it from anyone first. (Remember, one of the “rules” of selling short is that you have to borrow the stock before you sell it.)

Shorting a stock without borrowing it is called “naked short selling”, or “naked shorting”, and although it is illegal in the United States, it’s not illegal in some other places.

I just realized that I suggested the idea of Snookiepoo being naked.

Not a pretty picture for the puny mammals on this planet.

Put all her clothes back on, and move along, cuz.

If she had the ability and the nefarious intention, and if she could short the stock naked, then she could buy the floorless convertible debenture, and then when the time came, she could convert her debenture into stock (at a discount to the prevailing price) and use the stock she receives to cover her naked short position!

It sounds like that should be illegal, right?

Yes, it probably should be, but there are some instances when it’s not. And that’s the reason why “floorless convertible debentures” are so dangerous to the company that issues them.

It might be possible for Snookiepoo (she is holding the note) to short the stock “naked”, drive the stock price down, and then convert the debenture into stock (at a discount) and cover her short position.

If the sum of the money she collected on the short trade and the money she saved on the discounted conversion were more than the money she put into the bond in the first place, then she would make money…maybe a lot of money if the stock were driven down to the point where it was almost worthless before she had to buy it and cover her short position.

What else could go wrong, you ax?

Plenty. If the company were planning on issuing additional stock to raise the funds to pay back the money it borrowed when it issued the bond, then the company is kinda screwed.

The stock is almost worthless, so the offering would have to be much, much larger than would have been anticipated when the bond was issued.

A large offering of additional shares would dilute the float considerably, and that is something the shareholders would not like at all. (Remember, Snookiepoo just diluted the float when she converted.) The ordinary shareholders would resemble charcoal briquettes at that point.

Here’s the point that a lot of investors miss:

Why would NARF issue a floorless convertible debenture in the first place?

To my way of thinking, there are only three reasons, and none of them are good.

Either the people that are running NARF are idiots, or the company is in so much financial trouble that it has no alternative, or the sellers are in cahoots with whoever buys the note and those sellers have no intention of using the money they raise for legitimate purposes.

No matter what the reason, no matter how “wonderful” the company claims it is or how much the investor likes the stock, the issuance of a floorless convertible debenture is about the biggest red flag you could possibly imagine.

The good news is that under most circumstances, the shareholders can (not necessarily will, but can) quickly learn about the issuance of a floorless convertible, and if they are nimble they may be able move on to a safer investment without too much pain.

I trust this assists your understanding, cuz!

My best wishes to you and Snookiepoo, and have a great week!

Your loving cousin,

Tastes Like Chicken

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