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Cash-Poor Companies Feed Investor Hunger for 'Happy Meals'

Critics Say Deals Can Exacerbate Problems for Issuing Companies
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August 19, 2013, 10:36 p.m. ET

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By MICHAEL ROTHFELD and TOM MCGINTY

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Molycorp Inc., a Colorado mining company, has done two 'Happy Meal' bond deals, in part to help finance a mine, above, in the Mojave Desert.

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When Energy Conversion Devices Inc. needed cash, the struggling solar-panel maker turned itself into what Wall Street likes to call a "Happy Meal." To make $316 million in bonds more appetizing, the company agreed to lend millions of its shares to hedge funds buying the bonds so they could simultaneously sell the stock in a bet against Energy Conversion's success.

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Cash-Poor Companies Feed Hunger for 'Happy Meal' Bonds - WSJ.com

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A subsequent crisis in the solar-power industry hit Energy Conversion hard. The bonds, issued in 2008, plunged in value, and last year the company filed for bankruptcy protection, wiping out shareholders. But the negative wagers paid off for the hedge funds. A Wall Street Journal examination showed that hedge funds that bought the bonds were positioned to earn upward of 20% on their investments. Facing meager returns on many fronts, some hedge funds have developed a taste for Happy Mealsdeals named after the McDonald's burger-and-toy combo. Companies strapped for cash serve up everything the funds need to profit: bonds that are convertible into stock if the borrower does well, and tools for betting against the company if its prospects sour. Hedge funds say being able to borrow shares easily to make the negative bets, called short sales, enables them to offset the risk of lending to struggling companies. But critics of the deals contend some bond buyers get involved only because the issuing companies facilitate their big negative wagers, and that their short selling can exacerbate problems for companies by driving down their share prices. Scot K. Vorse, a retired senior investment banker and former Energy Conversion shareholder, approached the Securities and Exchange Commission through its whistleblower program to complain about that offering and others like it. He urged regulators to examine whether the share lending was improperly characterized in securities filings as a way for investors to hedge their bond purchases, rather Enlarge Image than the oppositea way to bet against the stock, with the bonds being the hedge. The SEC hasn't taken any action. Mark Leevan, another former Energy Conversion shareholder, filed suit in San Francisco federal court in June against the bond underwriter, a unit of Credit Suisse Group AG, CSGN.VX -2.10% and unnamed hedge-fund investors, alleging a "fraudulent scheme to manipulate the common stock." The deal left the company vulnerable to "massive and prolonged short attacks," the suit said. Credit Suisse hasn't yet responded to the suit and declined to comment. Happy Meal deals are just one of the ways hedge funds extend credit to struggling companies. At least 24 companies have done 26 bond deals that used sharelending agreements since 2004, raising nearly $7 billion. Restrictions on short selling during the financial crisis slowed such transactions for a time, but five companies have done six deals since mid-2010, with the last one coming in January. Another solar-power company is currently registered to do one. Such deals can make shareholders nervous. "It's a negative slant on the stock from a perception perspective," says Brian Blackman, vice president for investor relations at Molycorp Inc., MCP -3.24% a Greenwood Village, Colo.-based mining company that has done two Happy Meal deals. Investors want to know "what do traders know that I don't?" he explains. "Executives don't like it because people are shorting the stockand everybody wants to see their shares go up and up." A Journal analysis shows that share prices of 19 of the 24 companies had fallen

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Cash-Poor Companies Feed Hunger for 'Happy Meal' Bonds - WSJ.com

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200 trading days after deals, by an average of 53%. Eight of the companies, 33%, had sought bankruptcy protection within five years. The five-year bankruptcy rate is 7.1% for about 788 U.S. companies that sold all types of convertible bonds since the beginning of 2004, according to a Journal analysis of data from market research firm S&P Capital IQ. Traders and bankers say the failure rate has more to do with the type of companies willing to sell Happy Meals than anything about the deals themselves, and that the investors in the deals aren't out to hurt the companies. Mikhail Filimonov, founder of hedge fund Odyssey Investment Management, who bought Energy Conversion bonds and shorted its stock at a previous fund, says such company failures shouldn't be blamed on short sellers. "If the company's business model is sound and the outlook is positive," he says, "eventually the short sellers will get squeezed and punished for the wrong bet." Lawrence McDonald, a former Lehman Brothers convertible-bond trader, characterizes the deals as one of the few financing options available for some companies. "It's the last saloon where you can get a drink," he says. In short sales, traders sell borrowed stock, hoping to return it later with shares bought at a lower price. Happy Meal deals represent a twist on a sophisticated hedge-fund strategy called "convertible arbitrage," in which traders buy a bond that can be exchanged for stock, then short the shares, exploiting price discrepancies between the two securities. In the traditional version, hedge funds borrow the shares from other investors, which occasionally can be difficult and costly. In Happy Meal deals, companies themselves lend the stockat a minimal cost to the hedge funds. The funds can make money if the companies' shares rise in value by converting their bonds into more-valuable stock. If the stock falls, their short positions often can more than make up for any losses on the bonds. "If they don't like the stock, they put on a much heavier hedge," says Mike Knox, a former bond trader and the founder of Xtract Research LLC, which helps hedge funds research bonds. "If the stock goes down they make money. If the stock goes up they don't lose a lot of money." Globalstar Inc., GSAT +0.66% a Covington, La.-based satellite-phone company, needed cash to launch new satellites and had no other financing options when it sold $150 million of Happy Meal bonds in April 2008. Executives hoped the cash would keep the company in business, according to people familiar with the events. Globalstar lent 32 million sharesmore than a quarter of its outstanding stockto deal underwriter Merrill Lynch to facilitate the negative bets. The hedge funds needed the stock because most shares were held by Chief Executive Officer James Monroe, leaving few available to borrow. The underwriter, now part of Bank of America Corp., declined to comment. Within three weeks, Globalstar's share pricemore than $4 at the time of the deal was down 21%. Mr. Monroe told shareholders in a conference call the month after the offering that investors were misinterpreting the negative bets connected to the share loans as a

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sign the company was in trouble, causing "an unwarranted drop in the stock price." Mr. Monroe declined to comment. More problems with financing and satellites followed. The global financial crisis hit. By the end of the year, its stock had slid to 20 cents. It isn't possible to determine exactly how much any particular bond investor made on the deal because they aren't required to disclose their short sales or the timing of their bond trading. The Journal analyzed quarterly public filings on the bond positions of the hedge funds, then calculated their potential profit if they had made what bond traders said would be a typical bearish stock bet on a company with questionable prospects. The Journal's estimate of potential return includes interest earned on the bonds and profits from short sales, and factors in potential losses on the bonds. One hedge fund positioned to benefit from Globalstar's share decline was Minneapolis-based Whitebox Advisors LLC, which invests in distressed companies and initially bought nearly $30 million of bonds. The Journal analysis showed that Whitebox was in a position to make nearly $25 million on its short sales as the stock fell to 27 cents in April, from more than $4 in 2008. Whitebox declined to comment. Bond interest payments likely generated about $6.5 million for Whitebox, according to the Journal's analysis. Although the bonds had lost about half their value, Globalstar replaced them earlier this year with new ones that now trade nearly at face value. Globalstar now is seeking Federal Communications Commission approval for alternate uses for its satellite spectrum, which it hopes will boost its fortunes. Short-selling pressure can come swiftly for some companies. Molycorp, the Colorado mining company, did a $414 million bond deal last August in which it agreed to lend up to $138 million in shares, according to regulatory filings. Mr. Blackman, the investor-relations chief, says the company did the deal because it needed money quickly. If the company performs, "the stock will take care of itself" despite the short selling, he says. Molycorp was already under pressure from investors because of cash shortfalls and problems developing a mine in California's Mojave Desert. Its stock, which traded at about $12 before the deal, fell to $9.52 in the days after, before bouncing back. Over the next two months, the number of shares sold short increased by 56%, according to short-interest reports. After a management change and another Happy Meal bond in January, the stock now trades at about $6. Aristeia Capital LLC, a New York hedge fund, accumulated more than $30 million of the first Molycorp bond issue, securities filings show. Although the bonds have declined 24% since the offering, Aristeia is in a position to gain about 5% on that deal so far if it maximized its short position, the Journal analysis shows. Aristeia declined to disclose its returns. Energy Conversion, the solar-panel maker based in Rochester Hills, Mich., had notched losses for years but seemed to be turning a corner in 2008. But the economic crisis made capital scarce, and competition was intensifying in the solar industry, so the company resorted to the $316 million Happy Meals offering. It lent 3.4 million shares8% of its outstanding stockto its underwriter,
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Cash-Poor Companies Feed Hunger for 'Happy Meal' Bonds - WSJ.com

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Credit Suisse, for distribution to bond investors. The offering documents warned that the "short positions establishedcould have the effect of causing the market price of our common stock to be lower." Soon the company's prospects worsened. Chinese manufacturers undercut prices, and demand for solar panels slipped. Energy Conversion's stock, which had fallen to $60 from $72 in the two months following the deal, dropped to 20 cents by yearend 2011. The hedge funds that bought bonds were positioned to profit. Wolverine Asset Management LLC, for example, bought $26 million of the bonds in 2008 and held most of them through 2011, securities filings show. That investment put the Chicago-based fund in a position to profit by nearly $9 million, a 34% return on its original bond investment, a Journal analysis shows. It would have lost about $14 million on the declining value of the bonds, yet earned nearly $23 million in bond interest and on short salesif it shorted as much stock as it was entitled to under the deal and held that position until the end, the analysis shows. Wolverine declined to comment. Hedge fund Diamondback Capital Management LLC bought Energy Conversion's bonds about six months after they were issued, after their value had decreased, securities filings show. Diamondback, now closed, acquired $37.7 million in bonds at reduced prices. Diamondback's investment produced a $12 million profit, according to a person familiar with the matter. The profit came largely from interest on the bonds, from buying more of them when the value fell and selling them when it increased, and from betting against its stock. By the time Energy Conversion's stock had dropped to 20 cents, its fate rested in the hands of bondholders. It was in danger of defaulting and it needed more money to upgrade its production line. Diamondback, SMH Capital Advisors Inc. and another investment fund represented bondholders in negotiations with the company. Energy Conversion "really couldn't come up with an appropriate game plan, and we didn't feel that providing additional capital was going to be beneficial for our clients," says SMH senior portfolio manager Morgan Neff. He says the firm didn't short the stock and bought the bonds at a discount. Energy Conversion sought bankruptcy protection on Feb. 14, 2012, and its assets are being sold off. Shareholders will get nothing. George Voetsch, 71, a retired marketing director who had 200,000 shares, says of the hedge funds: "The big money for them was on the downside."
Rob Barry contributed to this article.

Write to Michael Rothfeld at michael.rothfeld@wsj.com and Tom McGinty at tom.mcginty@wsj.com

A version of this article appeared August 19, 2013, on page A1 in the U.S. edition of The Wall Street Journal, with the headline: Cash-Poor Companies Feed Investor Hunger for 'Happy Meals'.
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