From: Alden James [aldenjames9@hotmail.com] Sent: Thursday, May 13, 2004 10:05 AM To: rule-comments@sec.gov Subject: File No. S7-23-03 Jonathan G. Katz, Esquire Secretary United States Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549-0609 Re: File No. S7-23-03; COMMENTS RESPONDING TO: http://www.sec.gov/rules/proposed/s72303/saulewing04202004.pdf Study Citing Efficacy of Exception to Proposed Rule 203 (locate and delivery requirements) for Short Sales Fully Hedged by Certain Public Company Issued Warrants and Rights Dear Mr. Katz: On April 20, 2004, William W. Uchimoto of SAUL EWING LLP submitted comments by Professor Walt Schubert supporting an exception to Proposed Rule 203 for warrants issued by OTC companies to hedge short sales. I write to dispute Professor Schubert's position. I have previously submitted comments posted on December 11, 2003 and February 13, 2004; see respectively: http://www.sec.gov/rules/proposed/s72303/ajames121103.htm http://www.sec.gov/rules/proposed/s72303/ajames021304.txt To dispute Professor Schubert, I quote relevant portions of his comments. I then apply his analysis to a real, now bankrupt, OTC public company, Fortel Inc., to demonstrate how warrants could have been used to achieve Fortel's bankruptcy in a risk less transaction for the financiers. Professor Schubert states in pertinent part: “Section II- Reduced Volatility The investor purchases rights and or warrants believing that the value of the company’s stock will rise. As the investor begins to earn profit he or she will often wish to hedge some of their profits by shorting the underlying stock. The investor, initiating a naked short position under NASD Rule 3370, must be net long or fully hedged. If the warrant is in the money, and assuming each warrant is convertible into one share, then a long investment in say 100 warrants can be fully hedged with a short position of 100 shares. For example, if the underlying stock price was $3.00 per share and the strike price of each warrant was $2.00 per share the investor is entitled, under NASD Rule 3370, to short up to 100 shares of stock. Of course the investor can choose to short fewer than 100 shares in order to stay net long in shares. Alternatively, if the warrant is out of the money, the shares the investor can go short are determined by the value of the warrant. For example, if the share price, in the example above, was $1.78 and the value of a warrant was $.50 then the investor would only be entitled to short up to 28 shares (1.78 * 28 = $49.84) for each 100 warrants long. The warrants are worth $50.00. The investor can short fewer shares than those calculated but not more. That means that the short position is “at least” offset by the long position and the investor cannot gain from falling prices and, therefore, has no incentive to push prices down. Table 2. Example based upon Black-Scholes Option Pricing Model Out of the Money Out of the Money At the Money In the Money In the Money Time Now 1 2 3 4 Warrant price* 0.17 0.65 1.29 2.03 2.83 Stock price 1 2 3 4 5 Strike price 3 3 3 3 3 Long Warrants 100,000 100,000 100,000 100,000 100,000 Value of warrants 17,036 65,038 129,308 202,964 282,674 Short shares 0 10,000 30,000 60,000 100,000 Net Position 100,000 90,000 70,000 40,000 0 Hedged Warrants (%) 0% 10% 30% 60% 100.% * Assumed values used in Black-Scholes model: R=.02; risk less rate of return ó=.5; volatility K= 3; strike price S= 1 through 5; stock price D= 1825 through 1460; days until expiration THE FORTEL BANKRUPTCY – FREE WARRANTS TO COVER PARALLEL SHORT POSITION (The Third Leg) From the Fortel Inc. public filings, the following excerpts are quoted from the indicated public filing. FORTEL INC., FORM 8-K July 27, 2000 ITEM 5. OTHER EVENTS On July 18, 2000, FORTEL Inc. entered into a Securities Purchase Agreement with two institutional purchasers under which it sold 2,191,781 shares of its authorized but unissued common stock for a gross purchase price of $5,000,000. The purchase price per share was equal to the average closing bid price of the common stock as reported by Bloomberg Information Services, Inc. on the five trading days prior to the transaction. The purchasers also received Repricing Warrants for each share of common stock purchased which expire after eighteen months and terminate (1) upon disposition of the related shares of common stock by the purchasers, and (2) after the per share closing bid price of the common stock, as reported by Bloomberg, has been equal to or greater than $4.5625 for twenty two consecutive trading days following the effective date of a registration statement registering the share for resale by the purchasers. The Repricing Warrants may be exercised at a price of $.001 per share on any day on which the average of the two lowest closing bid prices of the common stock, as reported by Bloomberg, on the ten trading days prior to the exercise date is lower than $2.7375 per share. The number of shares issuable upon each exercise is equal to (a) the number of shares as to which the warrant has been exercised multiplied by (b) the difference between $2.7375 and such lower average price divided by such lower average price. (See http://www.sec.gov/Archives/edgar/data/731647/000091205700033435/a8-k.txt) FORTEL INC., FORM 8-K November 17, 2000 1. REGISTRATION OF WARRANT. The Company shall register this Warrant, upon records to be maintained by the Company for that purpose (the "Warrant Register"), in the name of the record Holder hereof from time to time. The Company may deem and treat the registered Holder of this Warrant as the absolute owner hereof for the purpose of any exercise hereof or any distribution to the Holder, and for all other purposes, and the Company shall not be affected by notice to the contrary. 3. DURATION AND EXERCISE. (a)On any day during the Exercise Period on which the Adjustment Price (as defined in EXHIBIT A) is less than $2.7375 (which amount shall be subject to equitable adjustment for stock splits, reverse splits and similar events), the Holder may acquire up to a number of Warrant Shares calculated pursuant to Section 3(b) by delivering to the Company a Form of Election to Purchase. (b)On any date of calculation during the Exercise Period, the number of Warrant Shares available for purchase by the Holder shall be calculated in accordance with the following formula: (Applicable Share Number) x [(1.2 x Purchase Price) - (Adjustment Price)] ------------------------------------------------------------------------ Adjustment Price If the number calculated in accordance with the foregoing formula is zero or a negative number, the Holder [sic Company]shall not be obligated to transfer any shares of Common Stock to the Company [sic Holder]. (See http://www.sec.gov/Archives/edgar/data/731647/000091205700033435/ex-10_c.txt) FORTEL INC., FORM 10-K January 2, 2001 Private Placement of Common Stock: On July 18, 2000, the Company, through a private placement, issued 2,191,781 shares of common stock to two institutional investors, Deephaven Private Placement Trading Ltd. and Harp Investors LLC (the "Investors"), in exchange for $5,000,000. This private placement was pursuant to the Securities Purchase Agreement, Registration Rights Agreement and Repricing Warrants (collectively the "Agreements"), copies of which were filed with the Company's Current Report on Form 8-K filed on July 27, 2000. Proceeds of $4,726,500, net of placement agency and professional fees of $273,500, were received. Pursuant to the terms of the Agreements, the Investors have the right to demand additional warrants to purchase shares of common stock from the Company in the event the market price of the Company's stock falls below $2.28 [sic $2.7375] per share. The Company has registered 5,341,126 shares of common stock of which 2,191,781 had been issued as of September 30, 2000. Should the market price of the Company's common stock fall below $1.12 per share, the Investors could demand that the Company request that shareholders authorize additional shares of common stock such that a $6,000,000 value be maintained by the Investors. In the event that such authorization not be obtained, the Investors could demand liquidating damages of up to $6,000,000. (Page 42) (See http://www.sec.gov/Archives/edgar/data/731647/000091205701000952/a2034250z10-k.txt) Details of the Fortel financing discussed above show, as computed below, that on the date of registration the financiers could have possessed warrants with a fair market value exactly equal to the price they “paid,” ($2.28) per share of equity. VALUING WARRANTS WHEN THERE IS DILUTION Stock Price= 2.28 # Warrants issued= 2191781 Strike Price= 0.001 # Shares outstanding= 26,437,000 Adjusted S = 2.279922195 T.Bond rate= 2.00% Adjusted K= 0.001 Variance= 0.2500 Expiration (in years) = 1.5 Annualized dividend yield= 0.00% Div. Adj. interest rate= 2.00% d1 = 12.98131028 N (d1) = 1 d2 = 12.36893785 N (d2) = 1 Value of the call = $2.28 The situation at Registration Date for the financiers was this: Holder:2,191,781 Restricted Shares Issued @ $2.28 per share 2,191,781 Warrants valued at @ $2.28 per share 2,191,781 (Potential) Warrant Covered Short Position @ $2.28 per share On the registration date, the financiers $5,000,000 equity position could have been hedged by a short position covered by free warrants. By the time the value of Fortel shares eventually went to $0, the financiers could have had the return of their $5,000,000 due to their short position plus the proceeds from their sale of the restricted shares into the market once the holding period was satisfied. More experienced financiers could certainly garner even greater profits from this pool of restricted shares. Apparently, such conduct would not be illegal, but it is shocking to learn what the securities laws permit. Conclusion: Hedging with OTC warrants is the equivalent of naked short selling, adding more counterfeit shares to the market based on warrants whose value has been artificially inflated. OTC warrants give a financier every incentive to short the company he “invested in.” Professor Walt Schubert may be correct in theory but wrong in application. Manipulators simply change the financing terms to inflate warrant value to support essentially counterfeit share covered short positions. A warrant “sweetener” for financiers should be a reward for success rather than used as a tool to destroy the future of this country – the OTC company. Therefore, there should be NO exception to proposed rule 203 (locate and delivery requirements) for short sales fully hedged by certain public company issued warrants and rights . Sincerely, Alden James [aldenjames9@hotmail.com] _________________________________________________________________ Stop worrying about overloading your inbox - get MSN Hotmail Extra Storage! http://join.msn.com/?pgmarket=en-us&page=hotmail/es2&ST=1/go/onm00200362ave/direct/01/