Alliance's Story Sounds Too Familiar

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-basedbiotech 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 afterthe deal was done, the company's management and one member of its board ofdirectors 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 StephenMcGrath, also were awarded warrants that, if exercised, put about 45% ofthe 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 theinterests 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 actualfinancing plan had considerably fewer protections for shareholders thanthey one they voted on," added Miller. For these reasons, Miller droppedAlliance 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 apotentially lucrative human blood substitute. But the company's progresshas been beset by clinical trial failures and regulatory delays. That hassunk its stock and forced it into a seemingly perpetual quest for operatingcapital.

You can't fault angry shareholders for thinking poorly of companymanagement and the board. As of June 30, 2001, Alliance had an accumulateddeficit of almost $434 million, and it is still years away from generating anymeaningful revenue. The company's market value is only $19 million. Yet CEODuane 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 220,000shares, 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% ofthe company, before he decided to take part in the aforementioned privateplacement, which closed in December. Alliance shareholders approved thedeal 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 millionshares, or 30% of the company, to a new group of 33 individual andinstitutional investors. These investors also were granted warrants foranother 4.3 million shares of common stock. The financing plan had somegnarly terms, most notably a flexible price that gave investors moreshares 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 shareholdersthat Roth was one of these new investors, purchasing just under 255,000shares, according to a registration statement filed with the SEC. Joininghim was Stephen McGrath, the company's retired investment banker and anAlliance director since 1998. McGrath purchased more than 118,000 shares inthe private placement, according to the same SEC filing. Alliance's boardof directors, including Roth and McGrath, voted to approve the deal andrecommended its passage by shareholders.

"This is like a law school exam question: 'Can you guess the number ofthings wrong with this picture?'" said Nell Minow, a frequent commentator ofcorporate 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 theboard's fiduciary obligations," she added. "It appears, in this case, thatyou have a CEO who is taking part in a deal that allows him to do betterthan shareholders. That's a direct conflict of interest that the board issupposed to make sure doesn't happen."

And what about director McGrath also taking part in the deal? Minowsays that if Alliance wanted to have insiders like Roth and McGrath on bothsides of the company's financing, the deal should have been reviewed andapproved by a committee of independent directors, who should have receiveddue diligence from their own legal counsel and investment adviser. And ofcourse, shareholders should have been fully briefed and allowed to vote onthe proposal.

That didn't happen.

Alliance's Rosenberg says Roth and McGrath's involvement in the privateplacement was requested by the other investors, as a sign of theirconfidence in the long-term prospects for the company. Neither man has soldany of his shares, she added.

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

"We couldn't go into all the details of the deal with shareholders, buteverything was handled legally and by the book," explained Rosenberg. "Wehad a preliminary agreement in August, but then Sept. 11 happened, and itadded 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 ofany unexpected changes made to the private placement, especially changesinduced by the events of Sept. 11.

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

On the Board and on the Payroll

The controversy over the Alliance financing hardly made a ripple lastyear, 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 respectiveboards of directors at those companies didn't stop the fraud or otherwiseidentify the problems before they escalated. This renewed interest incorporate governance puts Alliance's directors in an uncomfortablespotlight.

It should come as no surprise, then, to find that Alliance's directors are tied closely to management, according to the company's mostrecent 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 remainingeight outside directors received contractual payments for consulting workfrom 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 contractresearch firm, was paid $24,000 by Alliance in fiscal 2001.
  • Helen Ranney, a retired medical school professor, receivesconsulting fees of $2,000 per month and free office space. She's been apaid consultant since at least 1994.
  • Thomas Zuck, the retired director of the Hoxworth Blood Center atthe University of Cincinnati, and one of the country's foremost bloodexperts, received $12,000 in consulting fees during fiscal 2001.
  • Jean Riess, a director since 1989 and a retired researcher, hasbeen paid by Alliance almost $900,000 in consulting and licensing fees,plus warrants, since 1995. In the last year he received a one-yearconsulting contract worth $78,000 plus another payment of $22,000. Theconsulting deal was renewed for another year.
  • Lastly, McGrath, the director who participated in the controversialfinancing deal, was an investment banker for Oppenheimer when thefirm (since purchased by CIBC World Markets) was Alliance's banker. Whilethere, McGrath generated fees by working on numerous stock and debt sales,acquisitions and licensing deals.
  • Alliance's Rosenberg says the company considers all its outsidedirectors to be independent, despite the ongoing payments tied toconsulting agreements.

    "The fees that we pay them are not substantial enough to make afinancial difference. None of them are reliant on these fees for theirlivelihood 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 ImCloneSystems have come under congressional scrutiny for their role in that blowup, especially because several directors -- including some highlycredentialed cancer experts -- had financial arrangements with the firmthat may have led them to overlook problems at the company and with itsexecutives, most notably the former CEO Sam Waksal. But there are fewImClones 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 biotechconsulting practice of Ernst & Young. He said that his biotech clients areheeding investor anger by taking real actions to strengthen corporategovernance.

    But still, biotech boards tend to be small and insular, like theboards of Silicon Valley technology companies. And while many biotech firmspopulate boards with A-list doctors, researchers or retired seniorpharmaceutical executives, their pre-eminence in the medical professiondoesn't mean they're equipped to stand up to management and protectshareholder interests, especially if they're paid consulting fees. Dr. JohnMendelsohn, one of the country's top cancer doctors, sat on the boards ofboth ImClone and Enron.

    Alliance shareholders might have been appeased if the financing plan,while toxic and dilutive, actually had helped the struggling company remainin 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 workingon raising capital and may have something to report when it releasesresults for its fiscal year in September.

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

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