One of the uglier sides of the technology-stock meltdown was the way average shareholders in cash-starved companies lost much of their equity in refinancing schemes known as "toxic convertibles." This kind of bailout, sadly, was often deadlier than the disease, leaving existing shareholders with virtually nothing, while vulture investors fed on the corporate corpse.

Alliance Pharmaceuticals ( ALLP), a small, struggling San Diego-based biotech firm, opted for last-resort refinancing late last year, transferring a large portion of the company's equity to a new group of investors. But Alliance's refinancing had an ominous twist: Some of the new investors were actually the old investors -- specifically, company insiders.

Unbeknownst to Alliance shareholders, who were told only after the deal was done, the company's management and one member of its board of directors actually took part, as investors, in a controversial private placement that ended up selling off 30% of the company for just $15 million. Thirty-two investors, including Alliance's CEO Duane Roth and Director Stephen McGrath, also were awarded warrants that, if exercised, put about 45% of the company in their hands.

( All in the family: TSC looks at the relationship between the four brothers Roth: The top executives at Alliance's banker are brothers of the biotech's CEO and president.)

With a now-minuscule market capitalization, this biotech firm with a paltry institutional following is certainly no Enron or WorldCom. Still, Alliance exhibited corporate behavior that could raise red flags for investors at large: a self-interested CEO, corporate directors missing in action on oversight, and a rescue plan that put some insiders in a better position than average shareholders.

As is the case with most of these so-called Hail Mary financing deals, Alliance and its existing shareholders haven't fared very well. Just eight months after the bailout plan was completed, Alliance is again almost out of cash and struggling to survive. Its stock recently dipped under $1, despite a 5-for-1 reverse stock split in October.

And Alliance's board of directors, which is responsible for protecting the interests of shareholders, instead acted more like a rubber stamp for management. Five of the eight outside Alliance directors have, for years, accepted various consulting or service fees from the company, raising questions about their independence. A more independent board might not have allowed shareholders to think they were getting a certain deal when they actually got something quite different.

"We were incredulous to discover that members of Alliance management and its board were added to the list of investors, after shareholders had already voted on it," said David Miller, editor of the Nymble Investor Biotech Monthly, an investment newsletter.

"And it left an especially bad taste in our mouth, because the actual financing plan had considerably fewer protections for shareholders than they one they voted on," added Miller. For these reasons, Miller dropped Alliance from his newsletter's model biotech portfolio last September, before the company completed the financing.

It is worth noting that no laws appear to have been broken. And Alliance spokeswoman Gwen Rosenberg disputes the notion that the company did anything wrong. "The most important fiduciary responsibility we have to our shareholders is to keep the company going, which is what we did."

Small Company, Big Problems

Alliance is one of a handful of biotech firms trying to develop a potentially lucrative human blood substitute. But the company's progress has been beset by clinical trial failures and regulatory delays. That has sunk its stock and forced it into a seemingly perpetual quest for operating capital.

You can't fault angry shareholders for thinking poorly of company management and the board. As of June 30, 2001, Alliance had an accumulated deficit of almost $434 million, and it is still years away from generating any meaningful revenue. The company's market value is only $19 million. Yet CEO Duane Roth, with the approval of his directors, is paid handsomely.

In the company's last fiscal year, Roth's salary was bumped up 9% to more than $454,000. He also received a $200,000 bonus and stock options for 220,000 shares, according to the company's proxy statement filed with the Securities and Exchange Commission.

By comparison, Idec Pharmaceuticals ( IDPH), which is already profitable with two cancer drugs on the market, paid its CEO William Rastetter a base salary of $515,000 in 2001. Roth makes more than Millennium Pharmaceuticals' ( MLNM) CEO Mark Levin, who was paid $406,000 in base salary last year.

One of the biotech sector's hottest names, Gilead Sciences ( GILD), paid its CEO John Martin $548,000 in base salary last year. Recently, Gilead posted its first quarterly profit and is expected to stay in the black for the remainder of the year.

Roth already owned just under 1 million shares of Alliance, or 2% of the company, before he decided to take part in the aforementioned private placement, which closed in December. Alliance shareholders approved the deal in October, because without it, the company would go out of business. At least that's what they were told by management.

So Alliance raised $15 million by selling more than 4.3 million shares, or 30% of the company, to a new group of 33 individual and institutional investors. These investors also were granted warrants for another 4.3 million shares of common stock. The financing plan had some gnarly terms, most notably a flexible price that gave investors more shares the lower the company's stock price sank.

That's why the deal was considered toxic, because it encouraged investors to short the stock before the financing closed, in order to gain control of a larger share of the company. Nevertheless, Alliance shareholders voted to approve the reverse stock split and the private placement.

Did We Mention?

It wasn't until the deal closed, however, that the company told shareholders that Roth was one of these new investors, purchasing just under 255,000 shares, according to a registration statement filed with the SEC. Joining him was Stephen McGrath, the company's retired investment banker and an Alliance director since 1998. McGrath purchased more than 118,000 shares in the private placement, according to the same SEC filing. Alliance's board of directors, including Roth and McGrath, voted to approve the deal and recommended its passage by shareholders.

"This is like a law school exam question: 'Can you guess the number of things wrong with this picture?'" said Nell Minow, a frequent commentator of corporate governance and co-founder and editor of the Corporate Library. "There are just so many violations here."

"If all this went undisclosed to shareholders, it's a violation of the board's fiduciary obligations," she added. "It appears, in this case, that you have a CEO who is taking part in a deal that allows him to do better than shareholders. That's a direct conflict of interest that the board is supposed to make sure doesn't happen."

And what about director McGrath also taking part in the deal? Minow says that if Alliance wanted to have insiders like Roth and McGrath on both sides of the company's financing, the deal should have been reviewed and approved by a committee of independent directors, who should have received due diligence from their own legal counsel and investment adviser. And of course, shareholders should have been fully briefed and allowed to vote on the proposal.

That didn't happen.

Alliance's Rosenberg says Roth and McGrath's involvement in the private placement was requested by the other investors, as a sign of their confidence in the long-term prospects for the company. Neither man has sold any of his shares, she added.

But why was their involvement kept from existing shareholders until after the deal was completed?

"We couldn't go into all the details of the deal with shareholders, but everything was handled legally and by the book," explained Rosenberg. "We had a preliminary agreement in August, but then Sept. 11 happened, and it added real uncertainty because raising money became incredibly difficult."

But Alliance's shareholder meeting didn't take place until Oct. 15, which, seemingly, should have allowed the company to inform shareholders of any unexpected changes made to the private placement, especially changes induced by the events of Sept. 11.

Roth didn't return phone calls seeking comment, and McGrath could not be reached.

On the Board and on the Payroll

The controversy over the Alliance financing hardly made a ripple last year, but then, that was before the current wave of corporate scandals. With the debacles at Enron, WorldCom, ImClone Systems ( IMCL), et al., investors, politicians and government regulators are wondering why the respective boards of directors at those companies didn't stop the fraud or otherwise identify the problems before they escalated. This renewed interest in corporate governance puts Alliance's directors in an uncomfortable spotlight.

It should come as no surprise, then, to find that Alliance's directors are tied closely to management, according to the company's most recent proxy statement.

Alliance's board consists of 10 directors, two of whom are insiders -- CEO Roth and his brother, CFO/COO Theodore Roth. (See related story on the Roth brothers.

Four of the remaining eight outside directors received contractual payments for consulting work from the company and have been paid consultants for at least seven years. Another director was Alliance's investment banker for years.

  • Carroll Johnson, president of Research Management, a contract research firm, was paid $24,000 by Alliance in fiscal 2001.
  • Helen Ranney, a retired medical school professor, receives consulting fees of $2,000 per month and free office space. She's been a paid consultant since at least 1994.
  • Thomas Zuck, the retired director of the Hoxworth Blood Center at the University of Cincinnati, and one of the country's foremost blood experts, received $12,000 in consulting fees during fiscal 2001.
  • Jean Riess, a director since 1989 and a retired researcher, has been paid by Alliance almost $900,000 in consulting and licensing fees, plus warrants, since 1995. In the last year he received a one-year consulting contract worth $78,000 plus another payment of $22,000. The consulting deal was renewed for another year.
  • Lastly, McGrath, the director who participated in the controversial financing deal, was an investment banker for Oppenheimer when the firm (since purchased by CIBC World Markets) was Alliance's banker. While there, McGrath generated fees by working on numerous stock and debt sales, acquisitions and licensing deals.
  • Alliance's Rosenberg says the company considers all its outside directors to be independent, despite the ongoing payments tied to consulting agreements.

    "The fees that we pay them are not substantial enough to make a financial difference. None of them are reliant on these fees for their livelihood or lifestyle," she says.

    In many ways, the situation at Alliance seems to be an exception, rather than the rule, in the biotech sector. Board members at ImClone Systems have come under congressional scrutiny for their role in that blowup, especially because several directors -- including some highly credentialed cancer experts -- had financial arrangements with the firm that may have led them to overlook problems at the company and with its executives, most notably the former CEO Sam Waksal. But there are few ImClones out there, say biotech experts.

    "With exceptions like ImClone and Elan Pharmaceuticals, there have been relatively few blowups in the biotech industry that indicated major corporate governance issues," says Scott Morrison, a partner in the biotech consulting practice of Ernst & Young. He said that his biotech clients are heeding investor anger by taking real actions to strengthen corporate governance.

    But still, biotech boards tend to be small and insular, like the boards of Silicon Valley technology companies. And while many biotech firms populate boards with A-list doctors, researchers or retired senior pharmaceutical executives, their pre-eminence in the medical profession doesn't mean they're equipped to stand up to management and protect shareholder interests, especially if they're paid consulting fees. Dr. John Mendelsohn, one of the country's top cancer doctors, sat on the boards of both ImClone and Enron.

    Alliance shareholders might have been appeased if the financing plan, while toxic and dilutive, actually had helped the struggling company remain in business. No such luck. Alliance was supposed to run out of cash, again, when its fiscal year ended June 30. Rosenberg says the company is working on raising capital and may have something to report when it releases results for its fiscal year in September.

    "In the era we find ourselves in, shareholders expect directors to be aggressive," says Miller of Nymble Biotech Investor. "Sure, Alliance would have disappeared without this financing, and it may have been the best deal available, but it would have been nice if the board had taken a more active role to actually find that out."