Predator or prey? The mysterious world of death-spiral finance

 Amid a flurry of lawsuits and countersuits, the murky world of death-spiral financings—one in which Toronto financier Mark Valentine loomed large—is coming to light

The Toronto Star
By Matthew McClearn
October 15, 2002

UNDER FIRE: Former Toronto stockbroker Mark Valentine and his now-defunct brokerage are emerging as central characters in a mysterious ring of death-spiral financiers.

Under the circumstances, Hunter Carr's first impression of maverick Toronto stockbroker Mark Valentine was surprisingly favourable. At the law office of Christian, Smith & Jewell in Houston, Carr sat opposite Valentine, then 31 years old, a business associate named Stephen Hicks and an employee from Thomson Kernaghan & Co. Ltd., the brokerage for which Valentine served as chairman.

The way Carr tells it, the encounter in February, 2001, resembled any gathering at which routine business matters are discussed — even sandwiches, salad and chocolate chip cookies were brought in.

"If you met him on the street, you'd like him," he says of Valentine. "He was just a nice young guy. A little bit arrogant, but nice."

But this was hardly your average meeting. The year before, Carr's company, Internet Law Library Inc., had arranged to raise financing through Hicks' firm. It proved disastrous, and the two groups were now meeting to discuss the lawsuits they had filed against each other.

During the next hour, Carr says he learned that the wealthy Valentine had provided half of the initial $3.5 million (U.S.)investment, and would be among his adversaries in court.

Carr's recollection: "Their message was basically, `We don't mind throwing $5 million at litigation.' And my response was, `You've never met anybody like me in litigation. I suggest you don't fight me.' They said, `We've heard that story before.'"

After five minutes of discussion, the two parties reached an impasse and turned to other topics — like the weather. "We had a pleasant lunch, said goodbye to each other, and that was it."

The deal in question turned out to be what is known as a death-spiral or toxic financing. The clauses and caveats found in such agreements can poison companies unwise enough to sign off on them. And increasingly, these financings are heading to law courts, where Valentine and his now-defunct brokerage are emerging as central characters in a mysterious ring of death-spiral financiers. (That's the same Valentine who was suspended by his own brokerage and the Ontario Securities Commission earlier this year — and then arrested by the U.S. Federal Bureau of Investigation).

Investigators waded into an untidy world of faceless offshore investors, oppressive financing arrangements and long-shot companies, some headed by ex-convicts and securities violators. All things considered, you've got to wonder: did Valentine and his associates prey on weak companies? Or did they get snookered themselves?

Convertible debentures. Structured equity lines. Convertible preferred shares. The instruments that bring about death-spirals can be bewilderingly complex. Simply put, they are quick financial arrangements between small (and often desperate) public companies and select groups of investors. Take, for example, a standard convertible debenture. It's a debt instrument that pays interest, but can be converted into common stock at a fixed price, often at a discount to the market price on the purchase date. Existing shareholders will see their ownership diluted — perhaps seriously — if the company issues a large number of shares to the debenture holder on conversion. But the debenture holder is also taking a risk: the company may not survive long enough to pay back the debt, or its stock could become illiquid or even be delisted. On the other hand, if the deal is crafted properly and the company spends the proceeds wisely, maybe everyone will be rewarded.

The devil is in the details. In a toxic convertible debenture, the debenture holder can convert the instrument for a larger number of shares if the underlying stock price declines after the financing. Theoretically, it's a way of protecting the debenture buyer from market risk. But the caveat — sometimes called a "reset provision" — is the mechanism that triggers a death-spiral. If the underlying stock collapses, the debenture holder can obtain mind-boggling volumes of shares, which results in crippling dilution.

In fact, critics allege, death-spiral investors can benefit more if the stock tumbles. And should they be particularly Machiavellian, they can make sure it goes into a tailspin.

Houston lawyer Wes Christian believes he's figured out how death-spiral rings work. They scan for vulnerable public companies listed on small-cap bourses such as the American Stock Exchange and the Nasdaq Over-the-Counter Bulletin Board.

"They look at the float, they look at the liquidity in the stock, they look at how much they can pump it and how much they can dump it," he says. They approach prospective victims and tell them: "We like your company. We like your business plan. We like your management. We like your board. We'd like to make you a loan, or we'd like to invest equity in your company."

But while the financiers promise much-needed capital, others within the ring start short-selling the company's stock. Other potential investors are warded off by the tumbling share price, but the ring holds on. "They say, `We're gonna stick with you, buddy. We're in it for the long haul,'" Christian continues.

A death-spiral financing is soon hammered out — invariably through an offshore entity. "They say, `We're going to loan you $3 million during the first tranche, and $25 million on the second tranche. But, incidentally, we're not going to give you that second tranche if your stock falls below $1.50.' At the time, the stock is $7. So you're saying, `Hell, it ain't going below $1.50 — not with this money behind it.'"

The ink is scarcely dry on the agreement, Christian explains, when the ring begins selling shares, short-selling and employing other techniques to drive the share price down further. "What you don't realize is, they're gonna help get it below $1.50, so they're off the hook for the $25 million," Christian seethes. "Rarely have they funded the second tranche."

Compounding matters, says Brian Overstreet, a private placement expert and president of San Diego-based PCS Research Technology Inc., other unrelated investors within the short-selling community will pounce on any company that signs a death-spiral financing.

"Once the stock starts trending down, a lot of people jump on the bandwagon, and it can get real ugly real fast," Overstreet says.

The stock tumbles into a death-spiral, and the financiers begin demanding conversions. They can use those shares to cover their short positions, profiting handsomely from the difference between the price at which the stock was sold short and at which it was converted. If the death-spiral ring can drive the company into bankruptcy, they may not even have to cover their position at all. And the kicker: Christian suspects that the money from the first tranche comes from short-selling profits. "They frigging lend you your own money!"

The alleged pattern — or slight variations of it — appears in at least a dozen death-spiral lawsuits (seven of them for which Christian is serving as co-counsel with Houston litigator John O'Quinn). His theory has yet to be tested in court.

Other U.S. companies — including Global Intellicom Inc., ConSyGen Inc., Vitafort International Corp., Americas Senior Financial Services Inc. and Mobile P.E.T. Systems Inc. — have alleged similar behaviour by death-spiral financiers in past court actions. Those companies collapsed or settled out of court.

Among the few firms to go the distance was Toronto-based D.G. Jewelry Inc., which sued Hicks' firm, Southridge Capital Management LLC, for alleged stock manipulation in connection with a death-spiral financing. In late 2000, a jury rendered an 8-1 verdict in favour of D.G. — a decision overturned by the judge, who said it had no basis in law and ordered D.G. to issue the 317,000 shares it owed offshore entity Haymarket LLC under a death-spiral agreement. An appeals court upheld the decision last January.

Names that appear often in death-spiral cases include Mark Valentine, Thomson Kernaghan, Steve Hicks and Southridge. Was there any wrongdoing? The jury's still out.

Hunter Carr used to be in the litigation support business. But during the 1990s, he formed a publishing company and operated Internet databases of legal information. If Internet Law Library (now called ITIS Holdings Inc.) could sign up enough law firms, judges and other subscribers, it could generate revenue and become self-sufficient. But to win them, it needed a substantial body of constantly updated material — and that would cost megabucks.

When Carr went looking for funding in 1999, he was unaware of the risks of so-called toxic financing deals, he says.

"We didn't necessarily know at that time what a death-spiral was ... and we didn't know that people used the death-spiral to drive your stock down and make money." He eventually hooked up with Southridge, Hicks' investment advisory firm in Ridgefield, Conn. In May, 2000, Internet Law raised $3 million by selling convertible preferred stock to Southridge's clients. Carr claims he was assured that "although they were buying the stock and would help keep the price up, they were really going to make their money when we became really successful."

Hicks and other employees repeatedly promised that Southridge would not short-sell or manipulate his stock, Carr alleges; in fact, he says, they explicitly agreed that they would not sell their shares for one year. Carr checked the references they provided, and was satisfied. But then things began to unravel.

Southridge's name didn't appear in the final draft of the agreement. In its place stood Cootes Drive LLC, an offshore entity registered in the Cayman Islands. In any case, Carr was looking forward to the second tranche, which was to bring up to $25 million through an equity line — money that Internet Law badly needed.

Trouble was, Carr says, the company's stock plunged even before the deal was signed. Over the next six months, Thomson Kernaghan, Cootes' broker, sent numerous notices declaring that Cootes wanted to convert 139 preferred shares for more than 3.1 million common shares. Reluctantly, Carr acquiesced.

In December, 2000, he secured another $500,000 from Cootes through a promissory note — but more conversion requests soon followed. With its stock in freefall, Internet Law wouldn't qualify for funding under the second-tranche equity line.

That's when Carr visited O'Quinn, Laminack & Pirtle, a prominent Houston law firm. John O'Quinn had successfully sued breast implant manufacturers and tobacco companies during his career. He agreed to take the case on a contingency basis. "Now they have to run John out of money," Carr says with a hint of Texan swagger. "And I don't think that's going to happen."

In January, 2001, Internet Law refused to convert any more of Cootes' preferred shares to common stock, which was then worth just 10 cents. By that time, it alleges, Thomson Kernaghan had a short position of nearly 1.5 million Internet Law shares. Later that month, Internet Law filed suit against Hicks, Southridge and several of its employees, Thomson Kernaghan and Cootes. The suit alleged that the group had engaged in stock manipulation, federal securities law violations, fraud, conspiracy and other misdeeds. Cootes soon fired back a lawsuit of its own, alleging that Internet Law had breached its contract by failing to convert. Internet Law's war had begun.

Paul Metzinger has the dubious distinction of having been burned twice by death-spirals in as many years. His Denver-based company, NanoPierce Technologies Inc., claims it has developed a microelectronics technology for making electrical connections. But the company experienced frequent liquidity problems, had negligible revenue and was losing millions. In late 1999, Metzinger signed a convertible debenture financing with Equinox Investors LLC. Soon, he alleged in court documents, Equinox was using short-selling and other techniques to deflate NanoPierce's stock price. To pay off the Equinox debt and clean up the balance sheet, Metzinger went looking for what he calls "replacement" financing.

His search led him to Southridge. At its offices in Ridgefield, he explained his situation to two representatives. According to Metzinger's account, Southridge agreed to provide replacement financing and promised not to repeat Equinox's behaviour. In October, 2000, the two parties agreed that Southridge's clients would provide $15 million in two instalments through a stock purchase agreement.

On the final draft of paperwork, however, Southridge's name wasn't there; the investing fund was an offshore entity called Harvest Court LLC. Also, Southridge insisted that Harvest Court needed "reset" rights to protect its investors against market declines, which would be determined on three dates: 65 days, 130 days and 195 days after the deal closed.

Metzinger agreed, and was optimistic. "For the first time, the company's balance sheet was totally debt free and we had substantial shareholder equity," he recalls. But the day after NanoPierce received its first $7.5 million, he says, someone began selling large blocks of shares. Within three months, the stock was down 60 per cent. On the first reset date, NanoPierce issued 2.1 million shares to Harvest Court. Given what was happening, the company wouldn't qualify to receive the second tranche of $7.5 million.

Metzinger hunted for explanations. He mentioned the Harvest Court deal to a friend in the investment banking community. "He did some digging," says Metzinger. "He called us up and said, `Paul, you've got some trouble ahead of you.'" The second reset date was quickly approaching, at which point NanoPierce would owe Harvest Court an additional 7.4 million shares, worth $6.7 million.

Metzinger went to O'Quinn. In late April, 2001 — just before the second reset date — NanoPierce filed actions in several U.S. courts against Harvest Court, Southridge and several of its employees, and Thomson Kernaghan. The suit alleges violations of federal and state securities laws, conspiracy, aiding and abetting and common law fraud, among other things. Concurrently, the company published a news release indicating it would issue no more reset shares to Harvest Court. The following month, Harvest Court fired back its own lawsuit, alleging that NanoPierce violated its purchase agreement. NanoPierce's war had begun.

Wes Christian is a busy man. O'Quinn will lead the litigation in court, but Christian is co-ordinating pretrial work with 50 lawyers across North America. During the past two years, Christian's and O'Quinn's firms have spent more than $6 million learning about death-spiral financing.

"I've got documents that'll fill up fifteen 20-by-20-foot rooms, floor-to-ceiling, wall-to-wall," he says. "I'm travelling around the country trying to catch these ########."

The Internet Law and NanoPierce cases are just the beginning. O'Quinn and Christian represent other companies in death-spiral suits: Hyperdynamics Corp., Restaurant Teams International Inc., Eagletech Communications Inc. and Inc. The latest, biotech firm Endovasc Ltd. of Montgomery, Texas, filed a $250 million suit in September. O'Quinn and Christian represent the cases on a contingency basis — and will get a substantial cut of any damages awarded. So far, the damages sought total $1.5 billion.

That number may grow. Christian is preparing to file another seven suits, and he's hunting for more plaintiffs from 800 death spirals he's identified. About 150 of them involve Valentine or affiliates, he claims.

"We're going to look at everything, frankly, so we can make more money." Not only that, but Christian is looking for new defendants. "This is bigger than Hicks and Valentine," he adds. "This has been allowed to occur though a lack of supervision by our NASD (the U.S. National Association of Securities Dealers) and other regulatory organizations — and equally, your organizations in Canada."

He cited the Canadian Depository for Securities Ltd. as "vulnerable" in the lawsuits.

None of the allegations have been proved in court. In Los Angeles, lawyer Michael Rosenblum is mounting a legal defence for Southridge in four cases. He's also representing Valentine in the Internet Law matter. This group of clients says that it does not engage in death-spiral financing: in the dozens of convertible deals Southridge has arranged, many companies "have used the capital we have provided wisely and gone on to become successful."

Christian's allegations are without merit, Rosenblum claims. In fact, his clients allege that Internet Law and NanoPierce were out to defraud them. The group disagrees with nearly all representations brought forth by Carr and Internet Law. Internet Law knew that an offshore fund would provide the money, it claims. There was no stock manipulation, no misrepresentation and no unauthorized sales. Any selling Cootes did was permissible — even expected — under the agreement. Internet Law's falling stock "was the result of market or other factors and not the alleged wrongful conduct" by the group. Far from benefiting from the drop, the group claims, it was injured by it — an injury compounded by Internet Law's refusal to honour the conversion agreement.

The group is also attacking Carr's credibility. An investigator it hired found that, in the early 1980s, Carr was arrested, indicted and convicted in federal court on one charge of conspiracy to defraud. For that, Carr was sentenced to three years in prison. (He served six months.) Paul Thayer, another Internet Law director, was indicted, pleaded guilty and was sentenced to four years in prison for obstruction of justice, stemming from a U.S. Securities and Exchange Commission investigation into allegations of insider trading. Thayer had lied to the SEC about his trading practices, and it cost him $550,000 to settle with the regulator. Internet Law deliberately concealed those facts from Cootes, the group alleges. Had Cootes known, it never would have invested.

Similarly, Rosenblum's clients contest almost every allegation brought against Harvest Court. Neither Harvest Court nor its associates ever sold short any NanoPierce shares, they claim. Any normal selling Harvest Court conducted was permissible and expected, they say, and Harvest Court never promised to do otherwise. There was no market manipulation — in fact, Harvest Court would have benefited more if the stock price increased. NanoPierce's court action, they allege, "involves nothing more than a company seeking both to avoid its contractual obligations because it is disappointed with its stock's poor performance ... and divert blame for its own failures to alleged third-party `conspirators.'"

And then there's Metzinger. The SEC took action against him in the late 1980s for participating in the sale of unregistered securities, making material misstatements and omitting critical information from opinion letters, news releases and reports. Without admitting or denying the SEC's claims, Metzinger signed a consent decree enjoining him from engaging in such activities.

Moreover, the group's latest court action alleges that Metzinger participated in a fraudulent scheme to inflate NanoPierce's stock, employing promoters and self-styled "analysts" (one of whom had only a high school diploma for credentials) to pump the stock on Internet bulletin boards.

Those touts, the group alleges, were sometimes paid in stock for their services. "Harvest Court purchased the shares at a price that was artificially inflated," it claims. Had Harvest Court known of these facts, it would not have invested.

Others also question the credibility of death-spiral victims. "The reality is, an issuer that's involved in one of these deals is going to have a tough time coming into a courtroom and claiming to be a clean-hands defendant," says Overstreet of PCS Research. "More often than not, the issuer knows that they're getting into bed with someone of lesser stature than Goldman Sachs or another top-tier brokerage. Yeah, they may have screwed you, but you probably knew it was coming."

The age of death spirals is over. At their peak in 2000, PCS Research recorded 395 such deals, worth $3.2 billion. But so far this year, only 103 have occurred — worth just $408 million. Even in the context of the decline in the over-all market for private placements during that period, it's a dramatic collapse.

"It's largely a business that doesn't exist any more, because everybody got tired of losing money," says Overstreet. "Public companies themselves have eliminated this from the market. They just won't do these types of deals any more, with anybody."

Given the numerous lawsuits, one wonders why any investor would agree to supply money under death spirals, either.

The public's understanding of Valentine's role in death-spiral financing remains confined to vague allegation. How much money he and Thomson Kernaghan invested in such schemes remains similarly unclear. According to PCS Research's data, Thomson Kernaghan and its various related offshore groups — with names like Queen LLC, York LLC, and Nash LLC — executed 36 investments since 1995, worth a total of nearly $61 million. Most of those were to the technology and communications sectors, and two-thirds of them were of the death-spiral variety. Southridge and its related offshore groups — Sovereign Partners LP, Dominion Capital Fund, Wilson LLC, Jackson LLC, and so on — were involved in another 46 transactions worth $125 million. Again, more than 60 per cent of them were death spirals.

Valentine may be unable to participate in future death spirals, even if there were a demand for them. His meteoric career came to a grinding halt in June, when Thomson Kernaghan took the unusual step of suspending his employment and barring him from its premises. That followed an internal investigation that revealed alleged improprieties in his trading activities.

When the Ontario Securities Commission reviewed those trades, it concluded that Valentine had put his own interests over those of his clients. Later that month, the OSC suspended him, arguing that his continued presence in securities markets constitutes a public hazard. Thomson Kernaghan has since been petitioned into bankruptcy, closed its doors and been permanently suspended. Former customers are suing.

The OSC, too, questions Valentine's death-spiral practices. In mid-2000, Thomson Kernaghan arranged such funding for Toronto-based JAWZ Inc. (co-founded by two of his associates, Robert Kubbernus and Cameron Chell).

According to the OSC, Thomson Kernaghan's research department issued a "buy" recommendation on JAWZ shares later that year, but didn't mention the firm's involvement in the death spiral to investors. At the same time, Valentine was motivating other clients to short-sell JAWZ shares, the OSC alleges. (JAWZ folded last fall.)

"Valentine failed to deal fairly, honestly and in good faith with clients," the commission concluded. Toronto securities lawyer Joe Groia is defending Valentine in the action.

For Valentine, it gets worse. The U.S. Federal Bureau of Investigation orchestrated Valentine's arrest in mid-August at the airport in Frankfurt, Germany. According to reports, he was preparing to board a Lufthansa flight to Toronto after examining a possible investment in a German brokerage. He's been indicted for wire, mail and securities fraud conspiracy, and for securities fraud — part of a massive sting operation nicknamed "Bermuda Short" that has so far charged 58 people.

The FBI claims that Valentine and an associate, financial consultant Paul Lemmon, offered to pay $7.8 million in kickbacks to an FBI agent posing as a mutual fund manager. In return, the agent's "fund" was to buy $29.4 million worth of shares in three small tech companies from Valentine.

Valentine spent more than a month in a prison south of Frankfurt, until he was escorted by U.S. marshals to Florida to attend a bail hearing in Fort Lauderdale on Sept. 23. Under the terms of his release on $500,000 personal bond, he must stay in Florida and remain at his condominium in Key Biscayne in the evening; he must also wear a security bracelet that police can use to track his movements.

"I've done nothing that is illegal," Valentine told reporters following the bail hearing. "I'm 100 per cent confident of my innocence, and I look forward to my day in court."

His lawyer, Michael Pasano, said he and his client disagree with "pretty much everything" in the charges.

For both plaintiffs and defendants, the death-spiral lawsuits could wind up being a long, expensive and potentially embarrassing legal nightmare. For small investors, they're a cautionary tale about the hazards of investing in small-cap companies.

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