SEC widens probe into 'death-spiral' schemes

The Financial Times
By John Labate in New York
March 9 2003

The US Securities and Exchange Commission has expanded a probe into suspicious short-selling trading activities to include market makers and broker dealers who may have been involved in so-called "death-spiral" financing schemes.

The heightened regulatory attention follows a $1m (620,000) settlement announced late last month by the chief US markets regulator against Rhino Advisors, an unregistered investment adviser in New York.

Rhino and its president were accused of engaging in manipulative stock short-sales in support of a convertible financing deal meant to benefit an offshore client. The parties settled the case without either admitting or denying the charges.

It is understood that more charges against other securities firms are expected to be announced in the near future, involving matters related to the Rhino transactions as well as other similar but separate trading schemes.

"These are the kind of violations that often occur with the assistance of other market professionals. Where that's the case, the commission intends to pursue matters and bring enforcement actions as appropriate," said James Coffman, assistant director of enforcement at the SEC. Officials at the SEC would not comment on details about continuing probes.

Short-selling - in which a trader generally earns a profit as the price of a company's share price falls - is seen as a useful market mechanism that enhances trading liquidity.

In recent years, however, a series of claims of abusive short-selling, or market manipulation, have been made with regard to loosely-regulated small company shares that tend to trade off the main US exchanges in the "bulletin board" market.

Such complaints have caught the attention of officials at the SEC, who are considering making updates to short-sale rules.

The Rhino case was substantial because for the first time the SEC pressed a civil action against financing schemes that several dozen small companies claim have driven down their share prices to such an extent that they were either forced out of business or came close to it. Any SEC enforcement action could involve fines or other penalties against participants, even if the parties agree to settle without admitting to the charges.

Such "death-spiral" schemes are said to involve extensive short-selling and pre-arranged trading, which is carried out prior to the exercise of conversion rights under the terms of a convertible debenture.

A "convertible" security is usually a bond or a preferred stock that can be converted into a different security, often shares of a company's common stock. In most cases it is the holder of a convertible who determines whether and when the conversion is to happen.

According to the Rhino complaint, such trading drove down the share price in Sedona, a Pennsylvania technology firm.

A client of Rhino had provided Sedona with $2.5m in financing as consideration for Sedona's issuance of a $3m 5 per cent convertible debenture.

The financing arrangement became more valuable to Rhino's client as Sedona's share price fell, according to the SEC.


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