SEC fines Rhino $1-million (U.S.) in Amro death spiral
by Brent Mudry
February 28, 2003
In the first major U.S. prosecution of naked shorting through a Vancouver brokerage in a death spiral financing, the United States Securities and Exchange Commission has fined Rhino Advisors Inc. of New York, which represented secretive offshore client Amro International S.A., $1-million for manipulating the price of Sedona Corp. shares. (All figures are in U.S. dollars.)
The SEC announced Thursday a consent settlement with Rhino, an unregistered investment adviser, and its president, Thomas Badian, 33, who jointly agreed to pay the million-dollar fine. Rhino and Mr. Badian also agreed to do their best to avoid future securities violations, and to hire an independent consultant, acceptable to the SEC, to review Rhino's compliance policies and procedures, and to implement the consultant's recommendations.
Amro, also known as AMRO, a company registered in the secretive offshore haven of Panama, and based in Zurich, Switzerland, was not named as a party in the SEC's civil suit, filed and settled Thursday in United States District Court for the Southern District of New York. Despite its copycat name, Amro International S.A. is believed totally unrelated to ABN Amro International, the European-based respected international financial group.
"We thank the B.C. Securities Commission for its assistance in this matter," SEC lead attorney Thomas Newkirk of Washington told Stockwatch. The identity of the Vancouver brokerage used as a short-selling conduit in the scheme is not identified.
"This case involves manipulative trading in the common stock of Sedona Corp.," states the SEC in its complaint. "Rhino and Badian contributed to a decline in the price of Sedona's stock price by engaging in large scale short selling."
The Rhino prosecution comes in the early stages of a broad review by the SEC and other authorities of the murky hedge fund industry. The most notable penny stock hedge fund player to be nabbed to date is Mark Valentine, the head of now defunct Toronto brokerage Thomson Kernaghan, who was arrested Aug. 14 in the Bermuda Short sting, an unrelated criminal prosecution.
The Rhino/Amro case sheds new light on the practice of death spiral financing, in which ignorant, desperate or complicit companies generally raise money by selling convertible debentures with fluctuating conversion terms. Shark financiers exploit the situation by aggressively forcing the stock price down, through illegal or legal shorting, resulting in a massive death spiral for the target company, as millions of shares are issued at progressively lower prices when the debentures are converted. Such deals are also called PIPE financings, or private investments in public equities, in industry jargon, or toxic debentures on the Street. (Not all such financings prove toxic for the target, however.)
The Sedona financing used a standard formula, in which debenture conversion would be done at 85 per cent of the volume-weighted average price, or VWAP, of the stock during the five trading days prior to the closing or conversion date. Thus, aggressive shorting leads to a double win, as it drives the price down in a risk-free fashion, and multiplies the number of shares to be issued, putting the target stock under heavy pressure for further rounds of hammering.
The SEC notes that Amro, the Panamanian-Swiss investor, provides convertible and equity line financing to companies in need of capital. The regulator notes that Rhino, controlled by Mr. Badian, manages funds for two overseas clients, including Amro. "Generally, it caused its clients to purchase debt securities directly from issuers, often securities convertible into common stock," states the SEC in its complaint.
Besides Sedona, Amro has taken a shine to numerous penny stock promotions, including Vancouver-based Stockgroup Information Systems Inc., which saw its share price collapse in the wake of an April, 2000, convertible death-spiral financing with Amro and Deephaven Management LLC, a U.S. company. Amro's investment in Stockgroup was also managed by Rhino. Stockgroup announced on Jan. 31 that Amro has converted the remaining $400,000 of its convertible debenture, at 32 cents a share. (At the time of the financing, Stockgroup shares traded at $3 to $4, which was also before the collapse of the dot-com euphoria.)
Amro's investment portfolio in recent years has included such promotions as Affinity Technology Group Inc., Bravo! Foods International Corp., Calypte Biomedical Corp., Focus Enhancements Inc., Focus Entertainment International Inc., Famous Fixins Inc., Group Management Corp., Greystone Digital Technology Inc., Medisys Technologies Inc., Netlogix Communications Inc. and SVI Solutions Inc.
The Rhino case may be broader. In numerous deals, Rhino used Dr. Batliner & Partner, a Liechtenstein-based trustee which has been under investigation in Europe, according to an article in September, 2001, by reporter Stacey Mosher of TheDeal.com, a New York-based investment and finance site.
In early coverage of the Sedona financing controversy, the reporter noted that Rhino manages two families of private funds, Creon Management and Amro International, whose investors are described as "European high net worth individuals," apparently based on Stockgroup filings. (In its complaint, the SEC notes Rhino "manages funds for two overseas clients," but identified only Amro.)
In its complaint, the SEC claims Rhino and Mr. Badian manipulated Sedona's stock price to enhance client Amro's economic interests in a $3-million convertible debenture issued Nov. 22, 2000. "The debenture, negotiated by Badian, prohibited Rhino's client from selling short Sedona's stock short while the debenture 'remained issued and outstanding,'" states the SEC.
"Despite this contractual provision, Rhino engaged in extensive short selling and prearranged trading on behalf of its client prior to exercising the conversion rights under the debenture. This short selling increased the supply of shares in the market and depressed Sedona's stock price," states the regulator.
"As a result of the depressed stock price, Rhino's client received more shares from Sedona when it exercised its conversion rights under the debenture than it otherwise would have received. Following the conversions, Rhino engaged in wash sales and matched orders to cover the short positions and conceal the client's involvement in the scheme."
The SEC claims that Rhino generally helped its clients purchase debt securities directly from issuers, often securities convertible into common stock. "On behalf of its clients, Rhino subsequently traded the common stock, often selling it short before converting the debt securities," states the regulator.
In this case, Rhino and Amro targeted Sedona, which produces and distributes customer management software for small and mid-tier businesses. The $3-million Sedona financing was finalized in November, 2000, seven months after Stockgroup's disastrous similar deal.
The SEC claims that between March 1 and March 29, 2001, Rhino and Mr. Badian directed a series of short sales of Sedona shares through an account at an American brokerage held in client Amro's name and controlled by Mr. Badian. At the time, Amro owned no Sedona stock. The regulator notes that Rhino did not deliver the shares that it was selling short by settlement day and the broker neither bought nor borrowed stock to cover these sales.
"In violation of the (Sedona) purchase agreement's prohibition against short selling, Rhino placed orders with the U.S. broker-dealer, who thereafter placed sell orders with another broker-dealer (the 'co-operating broker-dealer') in Sedona stock," states the SEC.
Each trading day in March, 2001, this second brokerage executed sales of Sedona stock in its proprietary account, often placed through various new electronic communications networks, or ECNs, which give anonymity to traders wishing to conceal their identity from the market.
To cover its shorts, the second brokerage bought shares from Amro's account at the first brokerage, through the ECNs and after the market closed. As a result, these short-covering purchases were not printed to the Nasdaq tape and were not included in reported volume for the day.
Through this cozy circle trading scheme, Amro shorted almost 873,000 shares of Sedona in March, 2001, of which more than 785,000 shares were sold short before its first exercise of conversion rights of its debenture.
These delivery failures triggered clearing failures at Depository Trust and Clearing Corporation, which in turn prompted the National Association of Securities Dealers to placed a shorting restrictions on Sedona shares on March 22, 2001. Under these restrictions, further short sales would be subject to a mandatory closeout if there was a failure to deliver the securities after 10 days.
Rhino was hardly stumped by this NASD restriction. It just did an end run around the U.S. regulator by shorting Sedona in an Amro account Mr. Badian controlled at a helpful Vancouver brokerage. (Canadian brokerages, especially those in Vancouver, are popular dodges from U.S. shorting rules, as they are not governed by the NASD.)
Rhino, on behalf of Amro, used this complicit Vancouver house to short a further 350,500 shares of Sedona between March 30, 2001, and mid-April of that year. "Rhino's (naked) short selling in the Canadian account continued to put downward pressure on Sedona's stock price," states the SEC.
The Rhino scheme was a winner. The aggressive shorting helped knock Sedona's market price down from $1.43 a share, the average between Jan. 26 and March 1, 2001, to 75 cents by March 23, after three weeks of continued shorting. Four days later, Amro did its first conversion at just under 80 cents, based on a VWAP of 94 cents. (Subsequent conversions the next month were done at prices down to 64 cents.) The SEC notes that in the five trading days prior to March 27, the conversion day, Mr. Badian's trading averaged more than 25 per cent of all Sedona volume.
This was not all. Under the skillful hand of Mr. Badian, Rhino rigged the market further. The SEC notes that instead of delivering the converted shares directly to U.S. brokerages where the short sales occurred, Rhino did wash sales and matched orders out of the conversion shares account to the short selling accounts. "This created the appearance that the accounts that had short positions were purchasing shares in the open market and not covering short positions with shares obtained through conversion of the debenture," states the regulator.
"On at least 10 occasions during April, 2001, Badian directed transactions involving no change in beneficial ownership of shares of Sedona stock or placed buy orders for shares while simultaneously placing sell orders of substantially the same size and price."
The SEC notes that Rhino's trading allowed client Amro to profit from the scheme in at least two ways. First, the short sales locked in a sale price for the Sedona shares that was higher than the conversion price for the shares ultimately used to cover the open short positions. Second, Rhino's short sales increased the supply of Sedona shares in the market and depressed the price. "As a result of the depressed market price, the client converted the debenture to a greater number of shares of Sedona stock, which were already discounted to the market, and which it then used to cover its previous short sales made at higher prices," states a court filing.
The SEC also claims Mr. Badian's Rhino failed to give a sworn response to the regulator's investigation order, which it is required to do under federal securities laws.
As noted, Mr. Badian and Rhino have now promised to clean up their act and do their best to steer clear of future securities violations. Although agreeing to voluntarily pay the $1-million fine, Mr. Badian and his company neither admitted nor denied ever doing anything wrong.
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