Replies to post #54375 on e.Digital Corporation (fka EDIG)

[chwdrhed]

Thanks for that, chip.

I'll preempt the gang and point out that your scenario pretty much describes the entire history of this company.

The best face that can be attached to this is that, finally, real products are being made and sold. A few more good deals and they just might turn the boat around.

[HotrodHans]

Very sensible report Chip.....thanks/

[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

[Cassandra]

chipperca: The following scenario is supported by the timing and facts of the various financings.

The previous S-3 for shelf shares was an extended process because there were multiple additions and corrections to both the S-3 and 10Q that were required by the SEC (especially in regards to description of risk factors and the effect of dilution). Both the S-3 and the 10Q had to be resubmitted multiple times.

During the registration process, e.Digital required cash and took out a bridge loan with I. Kant that was secured by 100% of the assets of the corporation and also put major restrictions on the sale of company-owned stock for a year.

When the registration finally became effective, the I. Kant restrictions hindered e.Digital's ability to raise cash from sales of shelf shares. I know that Collier beleived the investors behind I. Kant were shorting the stock. Indeed the first sale of shelf stock was to another mysterious off-shore shell, Apriori.

e.Digital was unable to pay back the I. Kant bridge loan and renegotiated it with a financing fee that raised the effective interest rate to 65.5%. Again, they were unable to pay off the renegotiated loan as it neared its due date so they brought in usual FOWs who put on a new loan to pay-off the I. Kant loan.

That loan and the previous secured loan from September 01 (involving some of the same FOWs) were refinanced by issuing the Series D convertibles at the end of Dec. 02 (a financing fee was added to the total value of the convertibles and shelf shares were issued to pay interest due). Therefore, the Series D convertibles brought no new capital into e.Digital.

As losses continued to mount in 2003, the company continued to sell shelf shares or use them to pay vendors - each sale was lower than the last (with the exception of the last sale, which was the same as the one before it).

When the shelf shares were all sold, the working capital deficiency continued to grow and was nearly $2 million at 9/30/03. The company revealed in the 10Q that would need additional financing for operations and to address the $750,000 15% loan for which they are in default and under a forbearance agreement until the end of Dec.

The Series E convertibles were issued to address this serious working capital deficiency, which tends to scare off customers who can't be sure that the company will be able to stay in business to complete projects. However, because the deficiency at 9/30 was $800,000 more than the capital raised, they may still have a working capital deficiency. That's why I would not be surprised to see more shelf shares registered in the pending S-3.

[owd3]

ahh.. actually they're good for at least one more thing.....

"It cracks me up that Cassandra throws out the words "Death Spiral", "Toxic", and "Floorless" when discussing the convertible shares E-Digital has issued. Those words are good for the shock value, but that is all."

They are also good for describing the TYPES of financing deals that EDIG completes with their "friendly" financiers. It would seem to me that if you have an issue with those words being used to described the horrible financing deals, you ought to direct your efforts to the management of the company that enter into these deals time and time and time again. Not the BB poster commenting on the deals management freely entered into.

" In reality, E-Digital probably had no other choice than to raise money using this vehicle. Here is my theory of why this happened: "

Well yes, that is what happens when you run a company into the ground over 13 years and burn through $75M+ without ever even getting a whiff of making PENNY ONE in profit. You find your choices rather limited because most conventional money sources understand the complete and utter failure and the company can not demonstrate enough of a future potential to convince conventional sources to lend them dime one. EDIG has to leave a CASH DEPOSIT for their credit cards for crying out loud; of course they had no other choice

"When the previous S-3 for shelf shares application was issued, the registration took longer than expected, and E-Digital management was convinced that there would be enough shares to get through the period of time required for profitability. When the retail and e-tail operations became costly, and capital had to be raised, they were out of shelf shares, and in order to cover the losses, had to take out short terms loans to cover these losses."

So what you are saying is that EDIG management botched and misjudged the registration process, misjudged the amount of capital required to enter the retail CE market, and had no clue as to how and do any type of long term contingency planning. Given the level of incompetence you have detailed here, is there any question as to why they cannot raise money without going into the shareholder pockets?

"Again E-Digital management was convinced that the O-1000 and IFE and F-10 would bring them to profitability quickly, and therefore there was no need for new shelf shares. But the revenues from these products now took much longer than expected, and more capital was required, so they needed another short term solution."

So what you are saying is that they learned absolutely nothing from the prior fumblings and repeated the same mismanagement, misjudgment of the markets, and poor contingency planning. Are you trying to convince us here that not only are they incompetent, they are slow learners as well?

"Obtaining a short term loan was probably out of the question, since anyone making this loan would be subordinate to the first loan, and nobody was willing to be put in that position. The only way to raise capital quickly would be to issue the Series D convertibles, which allow the financers to have a garunteed return in all possible cases. Again the E-Digital management only issued enough Series D shares to get them through the time required for what they were convinced would be profitability, and would no longer require any more capital."

Same mistake yet AGAIN? Wow, why doesn't someone send them a note or something? Help them out!! If you can figure it out, why can't they. I sure hope they learned their lesson this time.

"Again, delays in projects, and higher than expected costs put them in another situation where they required more capital. Since an S-3 registration is time consuming, and they still had the original outstanding loan, they had no other choice than to issue the Series E convertibles. These convertibles also garunteed the investors a return no matter the future share price. E-Digital management probably considers this enough capital to carry them through the period necessary before profitability."

OH NO!! I can’t understand how an intelligent person could make this mistake for what, a FOURTH or FIFTH time? Can't they go to the library and check out a book on capital planning? I am sure they could find a source on the web that would help explain to them what contingency planning is.

"Now it is likely that new shares will be registered with an S-3, both to cover the convertibles, and possibly to have shares on hand if more capital is required.

The current situation could have been avoided by either registering sufficient shares in the previous S-3 to cover the period of time where the company was losing money, or to at least have registered a new S-3 when the $750,000 loan was made, so that new capital would be available in time to pay off this loan. Of course nobody could predict that it would have taken this long to become profitable."

Nobody could have predicted it?? Are you sure about that?? I seem to have some vague recollection of one or two folks making predictions along those lines. Now the fact that you did not listen to them is certainly your choice, but that does not mean it wasn't predicted.

"Hopefully the previous poor capital planning is now behind us, and the company will register enough shares for any unseen future difficult situations."

Well yeah, I mean the learned their lesson after the first time, I mean after the second time, oops- I meant after the third time, errr, fourth ??…..anyway, I'm sure they got it now!!!

"Of course this is all just my theory of what may have happened, and it is always much easier being a Monday morning quarterback."

I was just wondering, did the thought that management has played this exactly how they wanted to at every step of the way ever occur to you. Are you sure they ever even wanted conventional financing? How do you account for the same mistake over and over and over?

Have you ever looked at other companies the same folks are involved with, seen any patterns?