SEC short target, brother face criminal charges in Sedona case
By Brent Mudry
December 29, 2003
Two American shortsellers face criminal charges in the first major U.S. prosecution of naked shorting through a Vancouver brokerage in a death spiral financing. A criminal complaint naming Thomas Badian and his younger brother Andreas Badian was unsealed Dec. 4 in United States District Court for the Southern District of New York. Both face one count of conspiracy to commit securities fraud.
Andreas Badian was arrested that same day by U.S. postal inspectors and released on $2-million bail, with $1.5-million cash, and ordered to surrender his travel documents and not to leave the U.S. (All figures are in U.S. dollars.) Thomas Badian remains at large and his current whereabouts are unknown. Both remain presumed innocent unless proven guilty beyond reasonable doubt at a future trial.
Both men, who worked for New York-based Rhino Advisors Inc., allegedly used offshore accounts in a death-spiral financing of Sedona Corp.
The criminal case comes nine months after the United States Securities and Exchange Commission jointly fined Rhino and Thomas Badian $1-million in a consent settlement of the regulator's civil case in February. The SEC defendants neither admitted nor denied any of the regulator's allegations.
The SEC notes that Rhino represented secretive offshore client Amro International S.A., which was not named as a defendant. Despite its copycat name, Amro International S.A. is believed totally unrelated to ABN Amro International, the respected European-based international finance group.
Neither the SEC case nor the criminal prosecution identify which Vancouver brokerage was used as a short-selling conduit in the Rhino scheme.
THE CRIMINAL CASE
The criminal prosecution was launched by United States Attorney Richard Comey, with Assistant United States Attorney Marcia Isaacson and Special AUSA William Stellmach serving as case prosecutors, after an investigation featuring the U.S. Postal Inspection Service.
The criminal complaint, based on a sworn deposition by Postal Inspector Ann Marie Williamson, claims that from November of 2000 to the summer of 2001, the Badian brothers, together with known and unknown co-conspirators, knowingly and willfully combined, conspired, confederated and agreed together to commit securities fraud. In the prime overt act cited, on March 20, 2001, Andreas Badian allegedly caused a broker at a New York brokerage to short shares of Sedona on behalf of the trading account of an unidentified offshore entity.
Investigator Ms. Isaacson notes she bases her allegations on information gleaned through interviews with various individuals, including executives of Sedona, a review of business documents provided to the SEC, analyses of Sedona trading prepared by the SEC, and audio recordings of conversations involving Andreas Badian and his co-conspirators.
The criminal complaint claims there is probable cause to believe that from November of 2000 to September of 2001, the Badian brothers and known and unknown others caused Sedona to make false and misleading public filings with the SEC which deceived investors, and they carried out a scheme to manipulate Sedona's share price.
Authorities claim the Badians and their co-conspirators executed the scheme by having an offshore entity, referred to as an unnnamed co-conspirator, loan about $2.5-million to Sedona under a convertible debenture financing. Under the terms, after a 120-day hold period, the debentures could be converted into Sedona shares at a floating rate, and the lower the stock price fell, the more shares the offshore entity would receive.
The financing agreement allegedly expressly prohibited the subscriber, the offshore entity, from engaging in any short sales. Contrary to this agreement, the Badians and their associates allegedly defrauded Sedona and its investors by shorting large quantities of stock through an account held by the offshore entity at a New York brokerage.
Investigator Ms. Isaacson, based on her review of documents and discussions with the SEC, notes that the unnamed offshore entity is a Panamanian company based in Zurich, while Thomas Badian served as president of Rhino, which purported to give investment advice to the offshore entity. The complaint alleges younger brother Andreas Badian, an employee of Rhino, directed trading in the offshore entity's brokerage account, while the two brothers exercised control over this account.
The criminal complaint claims that Thomas Badian, acting on behalf of the offshore entity, negotiated the $3-million convertible debenture financing with Sedona. In general terms, the complaint describes this financing as a type of toxic convertible, which could lead to a "death spiral" in the company's stock price.
In death spiral financings, 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.)
"There have been instances where holders of toxic convertibles short sell the company's common stock to drive down the price and thereby maximize the number of shares to which they are entitled upon conversion of their debentures. In many cases this scenario has been a 'death spiral' for companies, with the convertible debenture investors ending up with majority control of the financially weakened company because of the dilutive effects of the successively lowered conversion price," states the court document.
According to authorities, after Thomas Badian negotiated this Sedona toxic debenture on Nov. 22, 2000, with an agreement prohibited shorting, his brother Andreas Badian directed shortselling through the offshore entity's account. As an example, the offshore brokerage account shorted about 700,000 shares in March, 2001. The complaint notes that the shorting was naked, as the offshore entity did not tender notice of conversion until March 27, 2001.
The complaint alleges that the offshore entity repeatedly failed to tender Sedona shares to the brokerage for delivery within three days of each sale, as required by industry practice. This included a failure to deliver the 700,000 shares shorted that March, until later.
"Although I have not completed my review of the trading records for the offshore entity brokerage account, based on the analyses that I have reviewed, it appears that these short sales were designed to drive down the price of Sedona common stock so that the offshore entity could profit by covering its short positions with stock obtained at a price below that which it had sold short," states Postal Inspector Williamson.
The complaint includes details of taped recordings made by the brokerage for certain phone lines used by its brokers in speaking with customers.
According to these tapes, on March 20, 2001, Andreas Badian told the broker to sell Sedona shares with "unbridled levels of agression" on behalf of the offshore entity's account. After this call, the broker shorted 74,500 shares. The stock closed at 97 cents that day.
"The next day, on or about March 21, 2001, Andreas Badian congratulated Broker 1 on a 'good job,' noting that the company's share price had 'collapsed.' Badian then directed Broker 1 to be 'merciless' with Sedona," states the complaint. The broker then shorted a further 78,600 shares. Sedona's share price fell to 87 cents that day.
The complaint also shows a high-stakes game of hardball ensued. On March 27, 2001, the offshore entity notified Sedona of its intent to convert its convertible debentures into shares. Sedona refused, the offshore entity sued and Sedona countersued. The case subsequently settled.
The criminal complaint claims that prior to the litigation settlement, Andreas Badian sent an Oct. 25, 2001, E-mail to his brother Thomas Badian.
"It seems like we always knew what where (sic) doing was well not right but we set up all these elaborate structures with seperatye (sic) entities etc. for protection, now it seems like it was all for nothing, the separatenss (sic) of the corpso and accounts was is no protection at all. How did this occur? There is no way we can have this go into court. Not with the records and the endless trader testimony, the younger brother told his older brother in this message.
THE SEC CASE
The SEC filed and settled its similar case on Feb. 26, also in U.S. District Court for the Southern District of New York. Defendants Rhino and Thomas Badian jointly agreed to pay a $1-million fine, without admitting or denying doing anything wrong. Andreas Badian was not named as a defendant in this civil case.
The SEC case, which centered on the same Sedona death spiral, also revealed that an unidentified Canadian brokerage was used in the scheme. "We thank the B.C. Securities Commission for its assistance in this matter," SEC lead attorney Thomas Newkirk of Washington told Stockwatch at the time.
The SEC case also fleshes in other details missing in the criminal complaint.
According to the SEC, the failure by the offshore entity, identified as Amro, to deliver Sedona shares in March, 2001, triggered clearing failures at Depository Trust and Clearing Corp., or DTCC. As a result, on March 22, 2001, the National Association of Securities Dealers placed a short restriction on Sedona shares, requiring any future short sales to be subject to a mandatory close-out, or buy-in, if there was a failure to deliver shares within 10 days.
According to the SEC, 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 unidentified 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.
According to 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. 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. The SEC claims that under the skillful hand of Thomas 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.
These allegations were never proven in court. In their consent settlement with the SEC, concurrent with the filing of the regulator's civil case, Thomas Badian and Rhino neither admitted nor denied ever doing anything wrong.
The SEC continues to enhance its reputation for finding monkey business at Canadian brokerages.
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