The man himself.

Photographer: Ryan Lowry/Bloomberg Businessweek

Death-Spiral Convertible Financier Has a Lot of Fun

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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I frequently remind you not to take anything I say as legal advice, but I guess it's fine to take legal advice from this guy:

The financing technique is legal as long as the debts that are being paid off are real and the financier doesn’t kick any of the money from the stock sale back to the company, according to Mark Lefkowitz, another penny-stock financier who pleaded guilty in 2012 to breaking those rules. “The bottom line is, it’s supposed to be used for bona fide conversions of debt to equity,” says Lefkowitz, who’s cooperating with the FBI. He cut an interview off quickly, saying he was due to be sentenced soon and needed to check with his FBI handler before talking.

I mean, he should know what techniques are legal, right? Since he had to, like, hop off the call to go to prison for doing the other ones?

That's from Zeke Faux's amazing Bloomberg Businessweek story about Joshua Sason, a 27-year-old Long Islander who runs Magna Group, "which he describes as a global investment firm," though Faux describes it as "a pawnshop for penny stocks." Even outside of his financing techniques, Sason's life is shall we say colorful (lingerie-model girlfriend, high-school rock stardom, budding movie career, "plan to import sand from Israel and sell it as a collectible called 'Sand from the Holy Land'"). But here let's focus on the financing techniques.

Broadly speaking, the goal of these techniques is this:

  1. A small troubled public company wants money.
  2. All it has to exchange for that money is its own stock.
  3. It is shall we say inconvenient for the company to do a regular underwritten public offering of its stock, because such an offering would require a lot of expensive and awkward disclosure of just how troubled the company is, or because it would be hard to find buyers for all that stock at once, or both.
  4. And it is not legal for the company to just secretly sell stock into the market without doing a public offering.
  5. So it decides to place the stock privately with a smart financing source.
  6. It's not like the smart financing source wants the stock either! You don't get to be a smart financing source by buying penny stocks of troubled companies and holding onto them.
  7. But "company sells stock to smart financier, who then sells it to the public" is not a good way to get around No. 4: The securities laws cover not only sales directly by companies to the public, but also sales by companies to the public by way of an "underwriter," and a financier who buys the stock only to sell it a minute later looks, to securities regulators, like an underwriter.
  8. So you need to find a way to get stock into the financier's hands in a way that makes him comfortable he can get it out of his hands and into the hands of ... is it uncharitable to say "the unsuspecting public"?

Now I should pause here and say that this goal -- get stock from company to financier to public, get money from public to financier to company -- makes sense for the company (which gets money), and for the financier (who is well compensated for providing the financing), but is less obviously appealing to the public (who buys the risky stock without the disclosure of a public offering), and is very obviously not appealing at all to the Securities and Exchange Commission. The main point of the securities laws is to prevent companies from raising money from the unsuspecting public without registration and disclosure, so the SEC takes sort of a dim view of inventive efforts to do that.

So there is a long-running game in which penny-stock financiers find ways to get stock to the public, the SEC shuts them down, the financiers find new ways, etc. Here's a simple classic: The financier sells the company's stock short, selling X shares of stock into the market for $Y of proceeds. Then he gives the company $Z (Z << Y), the company gives him X shares of stock, and the financier closes out his short sale with the shares from the company. The financier is never long shares, and is never "really" short either, because he's arranged with the company to get shares to close out his short. So he's never at risk. This is a good trade, but also super illegal.

A variant on this classic uses convertible bonds. The company sells the financier a convertible bond in a private placement. The financier sells stock short, until he has sold enough shares to recoup his investment in the bond and make a profit. Then he converts the bond, gets the shares and closes out his short. Here the financier is at a bit more risk, because he does hold onto the convertible bond for at least a little while, and if the company goes bankrupt between the time that he gives it the money and the time that he finishes short selling and converts, he's out of luck. But he at least has a debt claim, and is never fully at risk on the stock. A nice thing about this approach is that this paragraph loosely describes convertible arbitrage, in which investors buy convertible bonds and hedge them by shorting stock. And that's totally legal, most of the time. But when it's clearly done with the intent of evading the securities laws -- with the intent of pumping out stock from company to public with only a fleeting stop-over chez the financier -- then it's not. It's a bit of a know-it-when-you-see-it kind of thing.  

One bad sign is a "death spiral" convertible, one that converts into a fixed value rather than a fixed number of shares. Normal convertible arbitrage is practiced with bonds with fixed conversion rates. One $1,000 bond converts into, say, 50 shares, whatever the price of the stock ends up being, that sort of thing. But a $1,000 convertible bond that converts into $1,000 -- or, for that matter, $2,000 -- worth of stock, whatever the price of the stock ends up being, is a much more dangerous creature. For one thing, it tends to push down the stock price: The financier sells stock, the stock price drops, the financier is guaranteed more stock, so he sells more, etc. until the stock price gets near zero.  Also, though, when the financier is guaranteed a fixed amount of money, he's not taking any stock-price risk, and he looks a lot more like he's just transmitting shares from the company to the public. So buying a death-spiral convertible, shorting a lot of stock and then converting is very much frowned upon.

But that can be fixed! One apparently viable approach is to buy a death-spiral convertible, not short the stock, wait six months and then convert it. Six months is a mildly magical time period for the securities laws: If you buy a security in a private placement from a company and resell it to the public immediately, you tend to be considered an "underwriter" and get into trouble under step 7 in my list above. (The specific form of trouble that you get in, by the way, is "rescission liability": People who bought the stock from you get to sell it back to you at the price they paid, which, in a death spiral, could get ugly for you.) But if you buy the security in a private placement, wait six months and then sell to the public, you are generally not treated as an underwriter, and can sell freely.  

This seems to have been one of Sason's strategies, e.g. with a company called Pervasip. From Faux's article:

On the surface, the $75,000 loan Magna offered seemed all right. It was in the form of an “8 percent convertible promissory note,” meaning it asked for an 8 percent return and gave Sason the right to convert it into stock. The fine print explained that if Pervasip didn’t pay back the money within six months, the lender could convert at a 45 percent discount to the market price. So, no matter where Pervasip’s stock was trading, the company had to give Magna shares that were worth more than $136,000—an 82 percent return in just six months. Essentially, Magna locked in a fixed return.

On the other hand, Pervasip had to survive -- with a tradeable stock -- for six months. So Magna at least took some credit risk there.

There are some even weirder moves. Mark Lefkowitz, who was quoted above providing legal advice to Businessweek, used the rather recherché technique of a 3(a)(10) exchange, which explicitly lets a company do exactly the unregistered company-to-financier-to-public distribution of stock that is the goal of all these transactions. The catch is that the shares need to be issued "in exchange for one or more bona fide outstanding securities, claims or property interests," and a court needs to sign off on the terms of the exchange "after a hearing upon the fairness of such terms and conditions."  Lefkowitz's problem was that the outstanding securities don't seem to have been all that bona fide, and he seems to have hidden some of the terms from the court. So that's why he's chatting with the FBI these days.

Sason seems to have done the 3(a)(10) exchange correctly:

Magna’s biggest score came in 2013, when it helped a Greek shipping company called Newlead avoid bankruptcy. The shipper, which once owned 15 tankers and container ships, was down to four vessels. It had enough cash to cover about a month of operating losses.

The deal had a twist. Instead of giving Newlead a loan, Magna paid some of Newlead’s lenders for the right to collect its old debts. After Magna sued Newlead to collect, the two companies quickly filed a settlement where Newlead agreed to give Magna discounted stock that it could sell right away. A New York state judge signed off on the arrangement.

Sason said in an affidavit filed in the case that Magna, together with an unnamed partner, paid off $45 million of debt and received stock that it sold for $62 million—a $17 million profit before expenses.

Here is that affidavit, which is quite an affidavit, as affidavits go! Here's the arrangement:

Specifically, the Settlement Agreement provided that the total number of shares of Defendant’s common stock to be issued to MGP would be equal to the sum of (i) the quotient obtained by dividing (A) $44,822,523.85, representing the total amount of the Claim, by (B) 62.5% of the volume weighted average price of NewLead’s common stock over the Calculation Period (as defined below) and (ii) the quotient obtained by dividing (A) $120,000 of Hanover’s legal fees and expenses incurred in connection with the Action, by (B) the volume weighted average price of NewLead’s common stock over the Calculation Period, rounded up to the nearest whole share (the “VWAP Shares”). The “Calculation Period” was defined in the Settlement Agreement to mean the shorter of the following: (i) the 220-consecutive trading day period (subject to extension under certain circumstances set forth in the Settlement Agreement) commencing on December 9, 2013, the trading day immediately following the date of the initial issuance of shares of NewLead’s common stock to MGP, and (ii) the consecutive trading day period commencing on December 9, 2013 and ending on the trading day that MGP shall have received aggregate cash proceeds from the resale of shares of Defendant’s common stock equal to $61,750,970.29, representing the sum of (A) $61,630,970.29, which is equal to 137.5% of the total amount of the Claim, and (B) $120,000 of Hanover’s legal fees and expenses incurred in connection with the Action.

And the stock was delivered in little drips over time:

Pursuant to the terms of the Settlement Agreement approved by the Order, on December 6, 2013, NewLead issued and delivered to MGP, as an initial issuance, 3,500 shares (adjusted to give effect to certain reverse stock splits effected by NewLead) of NewLead’s common stock, and the Calculation Period commenced on December 9, 2013, which was the trading day immediately following the date of the initial issuance of shares to MGP pursuant to the Settlement Agreement. Between on or about January 6, 2014 and June 12, 2014, NewLead issued and delivered to MGP an aggregate of 37,658,000 additional shares (adjusted to give effect to certain reverse stock splits effected by NewLead) of NewLead’s common stock pursuant to requests made by MGP in accordance with the formula and procedures set forth in the Settlement Agreement.

So: NewLead gives Magna a little stock (less than one 10,000th of the eventual total). Magna sells it. NewLead gives Magna a little more stock. Magna sells it. This keeps going for half a year. At the end of that period, Magna has sold the stock for $61.75 million, 137.5 percent of what it paid for it (in the form of debt forgiveness). That's guaranteed by NewLead: If the stock goes down, NewLead just delivers more stock, until Magna has gotten its $61.75 million worth.

It goes without saying that this is what the stock did over that period:

Source: Bloomberg

Pay attention to the scale on that graph. Faux:

The financing may have saved Newlead as a company—it avoided bankruptcy and bought new tankers—but it ruined it as a stock. The company has been so thoroughly pillaged that if you’d bought $3 million of shares in March 2013, just before Magna invested, you’d be left with a dime. Adjusted for reverse splits, the shares trade for 20 billionths of a penny—$0.0000000002. Newlead did not respond to a request for comment.

Now, of course, bankruptcy would have ruined the stock too. You can think of this trade as sort of a jury-rigged bankruptcy: Rather than file for bankruptcy, restructuring its debts in bankruptcy court and wiping out its shareholders, NewLead instead signed up to this trade, restructured its debts in state court, and wiped out its shareholders. Felix Salmon is a fan:

Thanks to Sason, Newlead managed to pay off $45 million in debt, avoided having to file for bankruptcy, and even bought new tankers. The share price was demolished, but that’s always a risk in the stock market, and especially in penny stocks.

That's true! It's not much comfort, though, to the person who bought $35,000 worth of stock in January and saw it trading for $31.50 in June.  That person might feel a bit deceived. He might even think that the hearing at which the court heard from NewLead and Magna, and approved this trade as fair to both parties, could have inquired a bit further into the trade's fairness to NewLead's public stockholders -- who, if you squint, bought a lot of stock from the company without the registration statement that would otherwise be required.

This is obviously, always, a tension in the securities laws: It is good for companies to be able to get financing, and it is also good to protect investors from being sold stock without complete information. Where registration and full disclosure stands in the way of financing, something has to give. The SEC, being after all in the disclosure-regulation business, might have a bit of a bias for full disclosure. Sason, being after all in the financing business, has a bias for financing. So far Sason seems to be winning.

  1. Obviously there are a lot of specifically sanctioned exceptions for private offerings to accredited investors, etc. The point is, you're not supposed to cleverly invent your own exceptions.

  2. Not legal advice! In particular, the SEC has lost registration-requirement claims in cases like this, which I find baffling, though it still has insider trading law as an avenue to shut this down: If you know the company will sell you shares, and you short in advance, then you're trading on material nonpublic information.

  3. I could talk about delta as an indicator of good-faith convertible arbitrage, but probably shouldn't.

  4. The Businessweek article has a good swirly graphic of the death spiral that captures this dynamic, and I commend it to you.

  5. Here's a classic SEC case in that vein, which accuses the financier of manipulation for shorting the stock. This is actually a little weird, if you think about it, because the financier doesn't care what price he gets for the stock, so he has no incentive to pound down the stock price (which is what you normally think of as manipulation). Rather, his incentive is to get all his shares out before converting. But that's a detail.

  6. There are restrictions, including that the company really ought to be current on its securities filings. Also, I mean, good lord, don't take my advice on this.

  7. Section 3(a)(10) of the Securities Act of 1933 (pages 12-13 here).

  8. That chart is split adjusted; the stock is currently at $0.022.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net