When formerly bankrupt

Redback Networks

(RBAKD)

opened for trading Monday morning

at $7.85 a share, the company's old shareholders got a shock: The common stock value of their stake in the network-equipment seller had been cut in half in the space of a weekend.

The riches-to-rags bubble casualty was able to get out of Chapter 11 thanks to a debt-to-equity conversion by its lenders that eliminated $467 million of debt. It was a major concession that saved the company from a possible delisting and won creditors the right to the vast majority of Redback's common stock and, within the strictures of market demand, determine how it was distributed and who priced it. The terms of that distribution were made clear from the outset.

Still, Monday's open was a stunner to those uninitiated in the realities of corporate turnarounds.

"The company gave away the store -- and the small investor got hosed again," said one retail Redback shareholder, who requested anonymity.

Such vitriol was common among Redback's retail shareholders, and indeed, might also prove unjustified, since the company issued warrants that help make up the value deficit implied by the pricing.

To be sure, it's normal for shareholders to take it on the chin in a bankruptcy. Usually their shares are canceled out completely. Monday morning's open of Redback's shares was somewhat unusual in that the old stock was still trading, its Friday price ostensibly representing a reasonable guess as to what it would be worth after the reorganization.

The math in Redback's reorganization is daunting but not incomprehensible. Broadly speaking, the company's equity value went from about $36 million last Friday to more than $400 million on Monday morning, reflecting the positive impact of the bondholders' debt-to-equity conversion.

The problem for existing shareholders was that their share in the company fell at a disproportionate rate. Because of the dilution created in the debt-for-equity swap, they went from owning all of a $36 million company on Friday to owning 4.5% of a $400 million company on Monday -- a stake worth roughly $19 million, or half of what they owned before (before the value of the warrants).

Here's how it worked. Redback had about 183 million shares trading on Friday at a closing price of about 22 cents, giving it a market cap of about $36 million. Upon reorganization, the 183 million shares were reverse split 1 for 73, leaving about 2.5 million shares outstanding. Then roughly 49.5 million more postsplit shares were added to the company's share base, representing stock handed out to former bondholders and landlords in exchange for their agreement to cancel the debt.

Any company that sees more than $400 million in debt wiped off its books with the stroke of a pen should see major appreciation in the value of its equity. The question for the bankers or market-makers involved in the pricing of Redback's new shares was, how major? The shares opened Monday morning at $7.85, meaning the 52 million outstanding shares had a total value of about $408 million. The value of the formerly $36 million company had gone up by about $372 million.

What happened to the old shareholders? Their 2.5 million shares were now worth about $19.6 million -- a close to 50% haircut in the time it took to open the stock. Again, however, it must be noted that Redback's warrants also represent real value to investors who understand their mechanics, and -- despite trading a thin market -- do close the gap between the old stock's valuation and its post-split price.

The transaction's promoters would also argue that a smaller stake in a healthier company is worth more than a bigger stake in a failing, debt-ridden enterprise that was facing delisting.

But the logic confused several Redback shareholders, who said they were expecting a price of about $16 based on the split. "Seems like the smaller investors who have less information are at a serious disadvantage," said one

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reader. "That's probably not improper, but is certainly doesn't seem fair."

Also concerned was Tim Mulligan, the founder of Forensic Advisers, a research firm that assesses the quality of earnings of public companies for subscribers to its newsletter. "It seems to me there is no continuity in the equity price if today's results show anything other than a drop from approximately $16.06 on Friday after adjusting for the split, less a small credit for the warrants received by the old shareholders," he said Monday.

For its part, the company seemed a bit hurt by the fuss. "We were using a very creative method to maximize value for our shareholders," said spokesman Steve Schick. "On Friday, investors owned a stock priced at 22 cents. Monday, it was selling for $7.85 cents, and the $467 million debt was off the books." Schick noted the beneficial impact of the warrants and portrayed the reorganization as an unusually generous one for shareholders.

On Tuesday, Redback shares rose 49 cents, or nearly 6.3%, to $8.35 a share.

The story has one more wrinkle: Trading volume of the struggling company had averaged 26 million shares a day since the beginning of October. On Dec. 31, volume leaped to 219.7 million, and the stock dropped from 29 cents to 23 cents, a loss of nearly 21%.

Some Redback shareholders wondered if there's wasn't something smelly about the sudden surge in trading.

But Marko Budyk, managing director of Helix Investment Partners in Los Angeles, believes the explanation may be less sinister. "Since I wasn't involved, I have to guess, but I'd think that these were tax-related moves," he said. "It's the end of the year, the vast majority of stocks are trading above 200-day moving averages, and people are looking for a loss" to offset capital gains on other holdings.

Many large funds make those kinds of moves very late in the year, simply because it takes some time to crunch the numbers in complex, tax-related transactions, he said.

"If you're looking for dark motives, does it really make sense to look at a 22-cent stock?" Budyk said. "It's hard to imagine."

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