By Nathan Vardi
January 26, 2007
If your entrepreneurial venture were desperate for capital, would you get it from a hedge fund? Sometimes that's not such a good idea. Consider Laurus Master Fund. The Cayman Islands hedge fund opened with $5 million under management in 2001 and has grown to $1.6 billion making investments in so-called PIPEs, or private investments in public equities.
In those deals the fund invests in a cash-starved, thinly traded public company. In exchange it gets securities--notes that charge interest, warrants and options--convertible into common shares of the company. Laurus claims it has achieved an annualized net return of 18.5% since inception. The people running Laurus from New York--brothers Eugene Grin, 49, and David Grin, 37--are making out pretty well, too. In addition to the standard 2% of assets and 20% cut of profits, they also collect a closing fee, an average 3.5% of each deal, which they liken to points on a mortgage. As for the companies they invest in? Not so well. On average they lose 30% of their stock price within a year of signing a Laurus pipe, says PlacementTracker, a San Diego research service.
PIPEs are a big business, drawing $28 billion last year from hedge funds. Some of the companies raising the capital are large, but most are desperate indeed, too small or too weak financially to raise money with a public stock offering. Some of the hedge funds providing the money are not financiers that you would select if you had a choice.
Originally from Ukraine, Eugene Grin became a vacuum cleaner salesman when he landed in the U.S. in 1979. Then he worked as a broker of penny stocks, among other investments, at F.N. Wolf & Co., the boiler room shut down by regulators in 1994. At Wolf one of Grin's clients was Gilbert Bornstein, a 54-year-old unemployed man who invested $32,000 with Grin after being convinced he could safely double his money through penny stocks. (Grin says he never made that claim.) Bornstein was soon stuck with $27,000 in losses. Nine years later a New York State judge determined that Grin owed Bornstein $40,000. Grin has yet to pay that bill, and the judgment remains outstanding. "He was superwealthy," Grin shrugs, by way of an excuse. "There was money in the family."
Today Grin and his younger brother, David, still traffic in penny stocks. But they do so through PIPEs. Hedge funds love these deals because the shares they get are often priced at a discount to the market to compensate for the fact that they can't be traded until they are registered with the Securities & Exchange Commission, which can take months. Meantime, though, hedge funds can value those PIPE warrants and options pretty much any way they want and calculate their net asset value accordingly. The larger the gain in a fund's NAV, of course, the more attractive it is to new investors.
And the more attention these deals may draw from regulators. "Improper trading practices in connection with PIPEs is a concern," says David Markowitz, an SEC assistant regional director in New York. "It's an area that SEC enforcement is looking at." The feds have so far focused on the improper shorting of stock. It is mighty tempting for a PIPE buyer to double-cross the company it is investing in by shorting the company's stock and using the conversion privileges with the PIPE investment to cover its short position. That earns the investor a quick spread but wrecks the target's ability to raise more equity capital. Such shorting is forbidden by Section 5 of the Securities Act. In September a U.S. Attorney charged Hilary Shane, a former hedge fund manager, with insider trading, accusing her of shorting Compudyne's stock after learning that Compudyne was contemplating a pipe fundraising. On Jan. 4 Joseph Spiegel, a onetime portfolio manager for a New York hedge fund, settled SEC allegations of his using PIPE shares to cover short trades and paid a $110,000 penalty.
Andrew Worden, 41, runs Barron Partners, a $150 million hedge fund that has invested $85 million in pipes since 2003. The fund flogs its expertise in microcap companies. It doesn't promote the fact that Worden in 1994 pleaded guilty to wire fraud--he stiffed brokers on shares they bought for him that decreased in value--and served two years' probation. "I was 23 years old," Worden says of his indiscretions, which were not prosecuted for five years.
In March 2005 Barron Partners invested $1.5 million in Cordia Corp., a Winter Garden, Fla. Internet-phone outfit 54% owned by Alexander G. Minella, who in 1993 was sentenced to up to six years in prison. Minella, then president of broker Wakefield Financial Corp., pleaded guilty to having "secretly rigged the trading in certain Nasdaq securities" by getting brokers to trade among themselves to manipulate prices.
Corey Ribotsky, 36, heads N.I.R. Group, a handful of Roslyn, N.Y. hedge funds with $630 million under management. His first business partner successfully sued him for stealing away their marketing and consulting firm. The florist at Ribotsky's wedding filed a $7,275 claim against him for failing to pay the bill.
So how does he do as a hedge fund manager? A Ribotsky PIPE, on average, precedes a stock-price drop of 54% a year after the deal, according to PlacementTracker. That still works for Ribotsky because of the way he structures a PIPE: He receives debt securities convertible into discounted stock, in an amount determined by dividing the principal by the price of the shares at the time of conversion, less a steep discount. The further a stock falls, the more shares he gets.
Since Ribotsky invested $1.5 million in 2005, shares in Med Gen are down from $1 on the OTC Bulletin board to a fraction of a penny. The Boca Raton, Fla. company had less than $1 million in sales from an antisnoring spray, diet pills and supplements. (Its biggest shareholder and chief executive is Paul B. Kravitz, the former president of AppleTree Cos., who paid a $25,000 penalty in 1996 to settle SEC claims that he failed to tell investors in an AppleTree offering that he planned to invest $250,000 in a gambling casino.) Ribotsky converted the debt into 171 million shares of Med Gen, at discounts of 40%, by September 2006. Did he sell his stake, triggering the stock-price plunge? N.I.R. lawyer Jonathan Schechter declines to say. "It is not us that makes a company lose its value--maybe a company hasn't executed its business plan," he says, adding that N.I.R. never shorts a stock.
One of Ribotsky's PIPEs, a $1 million investment in Roanoke Technology, a Rocky Mount, N.C. Web site designer, allowed N.I.R. to purchase newly issued shares at a discount of 50%; Roanoke's shares then traded hands on the OTC Bulletin board at 12 cents. After Ribotsky sued Roanoke when it didn't meet its loan payments, Roanoke countersued, claiming that N.I.R.'s selloff of shares was destroying the company.
Indeed, trading volume of Roanoke stock jumped from 180,000 to 2.4 million shares on the days Ribotsky's funds filed conversion notices, say court documents, and the stock price plunged to less than a penny. Both suits were settled. Roanoke chief David L. Smith Jr. ended up leaving the company and settling SEC charges in August 2006 that he improperly issued stock to consultants who sold them for $7 million and kicked back $4 million to him. Smith has been barred from acting as an officer or director of a public company.
When it comes to dicey partners, though, few are as accomplished as the Grins. They financed Francis O'Donnell, who has gotten to know the feds pretty well. Taking over as chief of Searchhound.com, an OTC Bulletin board stock in 2003, O'Donnell changed its name to Coach Industries, quickly built up a controlling stake in the Cooper City, Fla. firm and started acquiring limousine companies. Laurus backed him with a $6 million loan. On Jan. 5 O'Donnell pleaded guilty to being an associate of the Genovese crime family. The indictment also claimed that an FBI agent posing as a drug dealer was asked to launder proceeds through Coach in exchange for a fee. In addition O'Donnell is accused of luring a victim to his office, where Clement (Clemmie) Santoro allegedly held a gun to his head and demanded a $1.5 million payment.
The Grins invested $1.5 million in April 2004 with Magic Lantern Group, which marketed Canadian educational videos. Their introduction to the company came through National Financial Communications , owned by Geoffrey Eiten, a Needham, Mass. newsletter writer who flogged companies and claimed to show readers "how to make 5,000%" on their money. Magic Lantern's biggest backer was Lancer Management Group, a New York City hedge fund that blew up amid accusations of fraud.
Magic Lantern, which lost $15.9 million on sales of $2.7 million in 2004, began to disintegrate. Eiten was sued in September 2006 by William Galvin, Massachusetts secretary of state, for engaging in "widespread 'pump and dump' transactions by publicly promoting certain stocks at the same time he was selling them." Galvin released chummy e-mails between Eugene Grin and Eiten's company suggesting they team up to sell Magic Lantern shares. Eiten denies any wrongdoing. Laurus managed to eke out what it calls "a nominal profit" before Magic Lantern's stock collapsed.
In November 2004 Laurus agreed to lend Thomas Equipment, which makes skid loaders and hydraulic equipment in Canada, $22 million to finance acquisitions and operations. At the time the stock traded at 88 cents. Most of Laurus' loans were convertible into stock at prices of $1.50 a share; the Grins also bought 2 million shares for a penny each and received options to purchase 4 million more for a cent apiece. Helped by a steady stream of press releases, Thomas shares touched $8.99 in January 2005 on light volume.
What was driving the stock? James Patty, former interim chief executive at Thomas and a current board member, says that David Grin was constantly focused on Thomas Equipment's share price, even though the lack of liquidity in the stock meant that Laurus could not sell too many shares without driving down the price. Word came down from David Grin, says Patty, "that he couldn't allow that type of hit to his portfolio." Why? "My assumption would be he was looking at a valuation of the company in order to attract additional money into his fund," Patty says.
Ridiculous, says Eugene Grin. The effect of Thomas' high stock price on Laurus' net asset value "was never material." His valuation model, he claims, discounts severely for the lack of trading volume in a stock like Thomas. A good thing for Laurus: Thomas Equipment's two main units have filed for insolvency in Canada; it was yanked off the American Stock Exchange and now trades for 8 cents.
Eugene Grin says he never shorts a stock. He also insists that Laurus provides a valuable service--and is more like a bank than a hedge fund. "We have tens of thousands of people working because of our investments," he says. "It's a beautiful thing."
[ RGM Short Selling Home page ]