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Cash-Strapped Companies Turning More to `Toxic' Loans
By David Ward

New York, Oct. 10 (Bloomberg) -- Atlantic Technology Ventures Inc. had less than a year of cash left. Rejected by banks, the medical technology investment company turned to Chicago-based hedge fund Fusion Capital LLC for a $6 million credit line in exchange for discounted stock.

Atlantic Technology paid $664,000 in stock and a finder's fee to Fusion Capital in March. It never got any money because its shares fell 65 percent to below a minimum specified in the loan agreement. They were removed from trading on the Nasdaq Stock Market in August.

The loan, known as an equity credit line, is an increasingly prevalent form of finance for desperate businesses. Sales of equity and junk bonds have slumped and banks curbed lending as loans at risk of default almost doubled last year to $192.8 billion. Critics say the credit lines drive borrowers deeper into the hole and securities regulators say the risks are sometimes not fully disclosed. Investors say the transactions attract short sellers who push down the shares.

``This was a real trial by fire in the harsh aspects of corporate finance,'' Atlantic Technology Chief Executive Frederic Zotos said. ``I wouldn't recommend them unless you really know what you're doing.''

Sharks

The loans, pioneered in the last two years by hedge funds and used by some investment banks including Societe Generale and CIBC World Markets, give the lenders quick up-front fees. Lenders can also profit by selling short, or betting against, the stock of a company that wants to tap its equity line, then using the shares it receives at a discount to profit from the shares' drop.

The loans are the latest manifestation of so-called ``death spiral loans'' that are structured by investors to profit by driving down a company's stock through short sales.

``It's like jumping in a pool of sharks,'' said John Nelson, a portfolio manager for the Wisconsin Investment Board, the 10th- largest U.S. public pension fund with $67 billion in assets. Nelson warns companies it invests in against equity lines.

The loans continue to gain in popularity as typical sources of capital for risky businesses -- stock and junk-bond sales and bank loans -- dry up, especially after the Sept. 11 terrorist attacks.

With just 64 initial public stock offerings have been completed this year, the U.S. is on track for its worst year in at least a decade. There have been three junk-bond sales since Sept. 11 as the default rate reached a 10-year high.

Conversely, in 2000, there were 136 equity line loans totaling about $538 million, from 11 equity lines for $35 million in 1999, according to PlacementTracker.com. Through Sept. 24 of this year, 115 equity lines were issued and companies received $386 million.

Lenders

New York-based Acqua Wellington Asset Management and its affiliates are the largest issuers of equity lines. Acqua funds arranged $198 million in loans for at least 24 companies the past two years, according to PlacementTracker.com, a database compiled by DirectPlacement Inc., a San Diego investment bank.

Some investors oppose the loans, and in at least one case, blocked loans by CIBC World Markets to DMC Stratex Inc., a maker of wireless-networking products. USInternetworking Inc. and Leap Wireless International Inc. were forced by regulators to restructure loans from Acqua Wellington.

``We warn (companies) against doing equity lines or other financings which we consider to be toxic,'' said the Wisconsin Investment Board's Nelson. ``They attract shorts, and they also repel savvy buyers who know what this type of instrument can do to these stocks.''

On average, companies have received only 15 percent of announced lines, after paying hundreds of thousands of dollars in fees, PlacementTracker.com data shows. Some loan agreements contain provisions that prohibit companies from accessing the line if their stock drops. Other companies find that not enough of their shares trade daily to enable them to tap much of the line.

Lenders deny that they are investing for short-term profits. They say they are investing in companies whose prospects they say are bright.

``I'm not telling you every share is held forever, but when we take an investment our intent isn't flipping it,'' said Acqua Chief Investment Officer Isser Elishis, who formed the fund in January 2000 after leaving Hong Kong Shanghai Banking Corp.

Increasingly Popular

While the Sept. 11 terrorist attacks curbed junk-bond sales and bank lending amid concern the economy is tipping into recession, they have had little effect on the market for equity credit lines. At least four companies announced agreements since the attacks.

Cornell Capital Management, which was based in the World Trade Center, provided a $20 million equity line to Continental Energy Corp. even after Cornell's offices were destroyed, Continental Chief Executive Gary Schell said. Schell said he finalized the loan in cell phone calls with Cornell banker Robert Farrell. Cornell did not respond to messages seeking comment.

In a typical equity line, the company and the issuer negotiate a maximum amount the company can borrow. The companies tap the lines at their discretion. In return, the lender buys the shares at a discount of between 5 and 10 percent to the stock's current price.

Critics say that the investors begin shorting the company's stock when notified that the company wants to tap the line. In a short sale, an investor borrows shares and sells them in a bet the stock will drop and can be repurchased for a profit. In equity lines, the investors use the discounted shares they receive from the company to repay the shorted stock.

SEC

``We are concerned that these hedge funds may be acting as an underwriter, getting securities at a discount with the intention of flipping them, generally pretty quickly and in large blocks,'' said Michael McAlevey, the deputy director of corporation finance at the SEC.

The SEC in March tightened rules governing how the loans are issued, and the agency has forced at least three transactions to be restructured. Regulators questioned whether the companies were adequately capitalized to complete the borrowings, and they forced the loan sizes to be reduced. They also compelled the lenders to assume liability if they misrepresented the investment when they resold the stock.

``As a shareholder or a bondholder, this is not the financing you'd like to see,'' said Dmitry Khaykin, a telecommunications analyst with Gabelli Asset Management Co., a mutual fund family with $25.6 billion under management.


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