How a Pasadena Investing Firm Spun a Boom That Fizzled : Securities: Conversion Industries’ history shows it was involved in dizzying financial cross-dealings.
To skeptics, John P. McGrain’s financial empire at Conversion Industries was a house of cards waiting for a stiff breeze.
Last week, it was more than a breeze that blew through Conversion’s Pasadena offices: Within a period of four days, the American Stock Exchange decided to delist the company over disclosure issues, the stock lost nearly all of its value, McGrain resigned as CEO and some of Conversion’s dozen-plus affiliated businesses began scrambling to distance themselves from the spreading morass.
By Friday, Conversion had named a largely unknown investment banker as its new CEO and pledged an all-out effort to “repair its relationship” with the Amex, which had not taken such strong action against any firm in almost a quarter century. Meanwhile, with trading officially halted, Conversion stockholders still had no way to trade their shares, which sold as high as $33.25 in 1993 but were quoted at $1.38 last Wednesday.
Conversion’s future is far from certain now, but whatever its fate, the company’s investors should have seen the red flags long ago. Since the onetime Canadian energy firm metamorphosed into a self-styled investment company in 1991, it has engaged in more than a few financial practices that have raised Wall Street eyebrows.
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By using a controversial Colorado penny-stock brokerage to underwrite many of its spinoff companies, for example, Conversion virtually invited the scrutiny of “short sellers,” professional traders who make a living betting against stocks they believe are grossly inflated in value.
Conversion and its spinoffs were also involved in dizzying financial cross-dealings and interlocking directorships--some of which, the firm has acknowledged, gave the appearance of conflict of interest.
All of this was engineered by McGrain--who declined to be interviewed for this story--and a full-time staff of just 14 people in the company’s Colorado Boulevard headquarters. Despite the “Industries” in its name--and a stock market value of $170 million at its peak--Conversion does not manufacture anything; it exists solely to deal in shares of other companies.
Conversion’s stated mission is the “identification of, investment in and sponsorship of emerging growth companies.” The basic idea is to find intriguing little companies, pump money into them, then take them public via stock offerings 12 to 18 months later.
If Conversion could invest in a hot business concept at a cheap price, individual investors conceivably could be enticed to pay a higher price for the business later. Conversion could make money either by selling its stake in the business to new investors, or by holding the shares as they appreciated--and borrowing money against that stock to use for new investments.
Exactly why Conversion decided to enter the so-called merchant-banking business in the first place is not clear. From 1984 to 1991, the firm was involved in development of “alternative-energy” facilities, though little appears to have come of that.
McGrain, now 49, a former Southland stockbroker, headed Conversion all through the 1980s, when he also dabbled in oil and gas ventures. Officially Conversion remains incorporated in Canada; its stock first traded on the Vancouver Stock Exchange before migrating to the Amex in 1988.
Conversion attracted little attention with its initial investments, in 1991 and early 1992, in tiny entities such as an energy-management consultant and a Canadian oil exploration outfit named International Colin Energy. But things began to heat up in mid-1992, after Conversion raised $10.2 million in a new public offering of its shares and shares of International Colin.
To sell that stock, Conversion enlisted the services of Tamaron Investments, an Englewood, Colo.-based penny-stock brokerage that Conversion had previously used to underwrite small share offerings of companies in Conversion’s portfolio.
So close were the ties between Conversion and Tamaron, in fact, that Conversion CEO McGrain personally lent Tamaron $1 million to give the brokerage the capital it said it needed to launch Conversion’s 1992 stock offering, according to documents filed with the Securities and Exchange Commission.
Flush with cash in mid-1992, Conversion shifted into high gear. In one major transaction, Conversion agreed that October to take a big stake in a private Canadian oil well servicing company called Beta Well Service. Beta’s CEO, William J. Gordica, had known McGrain since the early 1980s and been a Conversion director since 1987.
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But instead of having Conversion inject cash into Beta, friends McGrain and Gordica did a trade: Conversion took 1.15 million shares of Beta from Gordica, and in return he got 307,874 shares of Conversion.
Then, using Tamaron, Conversion took Beta public in January, 1993, while also distributing more than half of Conversion’s Beta shares to Conversion shareholders in the form of a stock dividend.
Beta had been in difficult financial straits before the stock offering. But concurrent with the offering, the company heavily promoted its new business ties with Russian oil companies, touting sky-high profit margins on oil services contracts with the needy Russians.
The hype helped drive Beta’s stock from $7 to nearly $20 on the American Stock Exchange in the first half of 1993, in the process enriching 35%-owner Gordica--at least on paper--as well as Conversion and its shareholders.
McGrain and Conversion, meanwhile, were deep into many other new deals by mid-1993, advancing millions of dollars to small highly speculative businesses with the hope of quickly taking them public at a profit.
The concept--a sort of fast-paced venture capitalism for the small investor--appealed to Tom Dukes, a veteran Paine Webber broker in Pasadena. Dukes was among the investment professionals who put their own money--and their clients’--in Conversion and its affiliates.
“Conversion was like a cow that produced milk,” Dukes said last week--the “milk” being a stream of spinoff companies such as Beta and the stock gains they generated.
For the fiscal year ended June 30, 1993, Conversion booked $18.6 million in investment revenue, a fourfold rise from 1992, thanks to its spinoff successes.
At the same time, Conversion’s own shareholders--as they were being rewarded with a blizzard of stock dividends, rights and warrants in the spinoff businesses--likewise provided a ready and needed investor base for the new shares.
The larger the investor crowd within which excitement about a Conversion spinoff could be generated, the greater the chances that the stock would rocket--boosting the value of the remaining shares held by Conversion, which were its only real assets.
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But by the summer of 1993, Wall Street short sellers began to suspect that Conversion had built a house of cards. The shorts--traders who borrow stock and sell it, betting that the price will plunge--began to encircle Conversion as its stock hit $33.25 that June, a six-fold rise from 1992.
Conversion’s ties to Tamaron were one beacon for the shorts; several of Tamaron’s principals had previous ties to other Denver penny-stock brokerages that had been associated with stock deals that crumbled.
More intriguing for the shorts was Conversion’s decision in June, 1993, to create and take public CVD Financial Corp. CVD’s initial role was to be a lender to companies in which Conversion already had stakes. In effect, Conversion was creating a bank for itself, using fresh cash raised from the public.
Why did McGrain & Co. need a bank? Because although Conversion had set out to be an equity investor in small companies, several of its “investee” firms needed so much cash to stay afloat that Conversion also began making short-term loans to them--digging an ever-deeper hole for Conversion.
The prospectus for CVD’s stock offering put it bluntly: “Conversion’s lending activities were never part of its intended business and only arose as a result of the inability of the companies in which it had made equity investments to obtain debt financing from traditional sources.”
Despite the risks involved in creating CVD from scratch, investors in August, 1993, stepped up to buy $54 million worth of CVD bonds and stock in an underwriting co-managed by Tamaron.
CVD immediately assumed $4.4 million in loans made by Conversion to four of its investee firms, SEC documents say. In addition, CVD directors quickly approved contingent loan agreements worth $20 million, most of which was allocated for three Conversion companies: Bratcher Industries, a chemicals maker; trucker Joseph Land Group, and PDG Environmental, an asbestos-abatement firm.
By September, 1993, however, Wall Street doubts about the value of the companies in Conversion’s portfolio were growing, and its stock was being hammered. The number of Conversion shares sold short rose from 185,000 in July to 605,000 that September--12% of the total outstanding--putting further downward pressure on the per-share price.
It didn’t help that a new Conversion spinoff--an Anaheim-based start-up firm named Statordyne Corp.--had gone public that summer and quickly plunged.
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With Conversion stock at $12 in October, 1993--off nearly two-thirds from its summer peak--an incensed McGrain contended that he and the company were being victimized unfairly by the shorts. He asked the American Stock Exchange to investigate the shorts’ trading.
But by then Conversion was in a vicious downward spiral. Many of its assorted publicly traded stock investments--including Beta Well, Statordyne and CVD Financial--were slumping in price, effectively slashing Conversion’s shareholder equity.
At the same time, losses on Conversion’s investments in Bratcher, Joseph Land and a San Diego ship-repair business called Myriad Industries were mounting. By June of this year, Conversion’s bad-debt losses for the previous 12 months had reached $5.4 million, nearly double that of the year before.
After a brief rally in some Conversion stocks early in 1994, sellers took control again by spring. Tamaron, which itself had planned to go public with Conversion’s help, was forced to pull the plug on its offering. (Tamaron is now a shell of its former self, having sold its branch offices and accounts to Baraban Securities two weeks ago.)
Conversion began to take what appeared to be almost desperate steps to shore itself up. In April it sold one-half of a $500,000 promissory note interest to Canadian Polaris, a Canadian “clone” of Conversion set up in 1993. In June, Conversion cut a deal with Macdonald Capital, yet another of its affiliates, to inject $903,000 in capital into Conversion.
Finally, in a head-spinning series of transactions, Conversion in April cut its 52% stake in CVD Financial to 37% by selling 1 million CVD shares back to CVD for cash; then, in July, Conversion notified the SEC that it intended to raise its CVD stake back to at least 51% by buying CVD stock from current shareholders--including McGrain, who would be permitted to unload his 212,000 CVD shares.
Once Conversion’s portfolio began to collapse, the complex cross-dealings of its companies and officers only accelerated the process.
McGrain told Bloomberg News Service earlier this year that his personal investments in Conversion and affiliates totaled $25 million as of March. But that portfolio was to some undisclosed extent leveraged.
As a result, as Conversion’s various stocks continued to sink in summer, McGrain faced margin calls from his lenders, forcing him to dump hundreds of thousands of shares of his assorted holdings--including more than 200,000 shares of Conversion at prices ranging from $5.38 to $3.50.
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At some point along the way, the American Stock Exchange--historically regarded as a fairly lax cop--began to probe deeper into Conversion. Yet it appears that no one at Conversion was prepared for what the Amex announced last week--that it would seek to delist both Conversion and Beta over unspecified “disclosure” issues, a dramatic disciplinary move that the Amex last took with one of its companies in 1971.
Pending Amex hearings on Oct. 24, the exchange will not say what its investigation found. But Conversion, scrambling to salvage its stock listing, suggested last week that allegations of conflict of interest might be part of the problem.
On Thursday, Conversion’s board accepted McGrain’s resignation and also announced that Beta Well CEO Gordica had resigned as a Conversion director and that D. Grant Macdonald, who had sat on both Beta’s board and Conversion’s, had quit Beta. Those resignations “should eliminate any perception of a conflict of interest between the two companies,” Conversion said in a statement.
Dukes, the Paine Webber broker, insists that Conversion’s basic business plan was sound, and he argues that there is significant value in some of Conversion’s affiliates--including Beta--despite the stocks’ collapse.
But he concedes now that the nature of Conversion’s business allowed for “a great deal of self-dealing. That’s the weakness of the concept.”
Not surprisingly, some Conversion affiliates took pains late last week to note that the Amex has not painted them with the same brush. David Norris, president of North American Recycling, said his paper-recycling company is working with Donaldson, Lufkin & Jenrette Securities on a minimum $50-million bond issue that would in part extinguish debt to Conversion’s CVD Financial.
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For Conversion itself, of course, the paramount issue is whether the company has or can generate sufficient capital to survive, especially if its equity portfolio fails to rebound soon.
At June 30, Conversion’s shareholder equity was $10.5 million, a steep plunge from the $34 million of a year earlier. Moreover, Conversion is on the hook for $8.1 million in loan guarantees to CVD Financial for loans to Conversion affiliates. And in what hapless shareholders will probably view as adding insult to injury, Conversion owes its executives $2.5 million in bonuses accrued in 1993 but not paid.
McGrain alone--who was paid $240,000 in salary in each of 1992, 1993 and 1994--is also owed $902,999 in 1993 bonus money.
In its search for a successor to McGrain last week, the Conversion board of mostly McGrain cronies wound up picking Charles O. Thompson III, a 37-year-old former investment banker who came to Conversion in May from Sutro & Co., a mid-sized investment banking firm based in San Francisco.
In an interview Friday, Thompson conceded that “capital is an issue” as Conversion attempts to right itself; he declined to speculate on the company’s future.
Thompson said he had joined Conversion as head of merchant banking operations in May because “I wanted to be a patient investor (in small companies)--and I would still like to get back to that business.”
As for Conversion’s stock holdings, “some of our companies are more mature and some are less mature,” he said. “But as they become more mature, they should prove their worth.
“We have value,” he said, “but a lot of it just doesn’t trade right now.”
How Fortunes Declined
How stocks of companies that Conversion Industries helped take public and/or has invested in have fared since their initial offerings or distributions to Conversion shareholders; “C.I. owns” column is the percentage of stock held by Conversion on June 30.
Offering Initial ‘92-’94 Fri. C.I. Stock (mo./yr.) price peak close owns N.A. Recycling 2/92 $6.00 $12.75 $1.75 16% Intl. Colin Ener. 7/92 8.00 21.38 7.75 -- Beta Well Svc. 1/93 4.25* 19.88 2.75 9 Statordyne 6/93 3.00* 7.00 1.44 22 CVD Financial 8/93 3.75 5.88 1.00 34 Onsite Energy 2/94 NA 3.75 0.88 11 PDG Environ. 5/94** -- 4.00 0.88 --
* unit offering price; ** date of distribution to Conversion holders.
NA: not available. Company was formed via merger with another firm.
All stocks trade on Amex except PDG (Nasdaq) and Intl. Colin (NYSE).
Prices are adjusted for any stock splits.
Source: Securities Data Co.
