Sunday, February 3, 2013

Fraud, Bankruptcy, and Ethanex...

Ethanex is one of those companies that has an amazing story. Due to being an investment that requires a ton of digging and has such a wide bid/ask spread, has a super small market cap, and is bankrupt, almost no one would ever think to look at it. Personally, I think that there should be a book written about the legal situation that has and is continuing to unfold... In this post, I talk of the investment I have made in this tiny company with a market cap that is little more than $1 million dollars...

First and foremost, there are risks with this distressed security, however, it seems to be a lottery ticket with limited downside. Even if the stock ultimately goes to zero (which I see as unlikely), for me it's an attractive bet from a risk/reward ratio. Secondly, I want to mention that I was originally alerted to this situation by Thomas Braziel. He now owns just under 10% of the company and I represent a decent chunk of the company as well. Thomas also recently started a small fund that invests in some of the oddest securities that you will ever see and even recently filed a 13D on Winland Electronics (WEX). It's called B.E. Capital- look for them to do some really cool stuff.

For the sake of easy reading, I would suggest that you don't click on any links until you read the whole thing. There are probably more in depth ones here than any other write up I've done.

ETHANEX (EHTE)

Ethanex was founded in 2006 as a company that was to produce ethanol with a cheaper and more efficient process. In 2007, they entered into an agreement to buy an ethanol plant with a 26 million gallon capacity that was in the process of almost tripling that amount, with further expansions in the future. In 2008, Ethanex was bankrupt after not being able to secure financing for the deal that was in excess of $200 million dollars, and filed for liquidation. All members of the Board resigned and the company had been screwed by an attorney who was supposed to represent them in raising various forms of capital through "PIPE" transactions. In addition, this attorney was the corporate secretary and used various firms that he controlled to sell shares of the company at some pretty in-opportune (and very illegal) times. He sold unrestricted shares of stock, that should have been restricted shares, before the securities were even registered... Interestingly, he had already written a legal opinion stating that all issued shares should have a restricted legend, but as mentioned, managed for his to be unrestricted. As a result, the company was thrown into liquidation and Louis Zehil went to jail after reaping over $17 million in illegal profits... You can read some more of the specifics here, here, and here.

Given that Ethanex is liquidating, there are a whole host of legal issues involved, and at the bottom of their website there is now a link for a "cougar" hookup site... what could possibly be attractive about it?

At last report (view at Scribd), the estate is more or less solvent, with most all liabilities having been paid (except for some accruing legal expenses). There has already been one fat check cut to the estate from the government, and there is a good likelihood of another one coming from another branch (here is the docket, see item 32). Other than the ongoing legal fees and any new claims that may come in, that seems to be it. Alone, the remaining shell or the company seems attractive at a certain price, based on your own analysis of various items and such. I for one, started buying shares around 5 cents a piece and have averaged my cost up a bit... Thomas got all of his shares in the single digits.

Somewhat ironically, the accruing legal fees, that on the face of things seem to hurt the estate, are the part of the investment thesis that makes EHTE so interesting (both in terms of a lottery ticket and how interesting I find reading the case). The reason being that there is a outstanding lawsuit against Zehil's former law firm that is set to go to trial on May 6, 2013... It has already been delayed several times for various reasons, and could hypothetically be delayed again. However, the overall case seems pretty promising and most of the fees have already accrued  for example, all the discovery, the costly part of a lawsuit, is finished.

As is with any legal action there is risk, however, here are the items that I like about the lawsuit:

1) Zehil has already pleaded guilty to conspiracy and fraud. He went to jail and is presently residing in a halfway house at time of publication, due to being "helpful in the investigation..."
2) Zehil was a partner at the legal practice presently being sued by Ethanex at the time he undertook the illegal activities.
3) Overall, it seems pretty easy to prove that the law firm didn't have the oversight of Zehil they should have.
4) This all looks REALLY bad for anyone defending the case (jokingly, it seems to make Goldman look like an altar boy...)

Normally, a large lawsuit bankrupts a practice, even with insurance. If they were to settle, it could nearly destroy many. However, this is a special case, as the firm should have some pretty deep pockets and probably will want to avoid any more negative publicity.

This probably leaves you with a few questions...

"The defendant in the case?"

McGuire Woods... a multinational law firm with over 900 employees...

"The amount being sought?"

Well in excess of $50 million dollars...

What makes this interesting, is that Louis Zehil didn't just do this to Ethanex... he engaged in similar company-wrecking actions to 6 other companies. So, if McGuire Woods were to settle, then it seems that they would also need to settle with a bunch of other firms. To me, this leaves it up in the air if they will push for a settlement or take their chances in front of a jury- after all, if they lose this case, then what more are they subject to? Either way, I really like the odds for Ethanex, especially since they are represented by the Edgar Law Firm, which has a really good record of delivering for it's clients- once negotiating a settlement from Squire Sanders & Dempsey LLP for $43 million in a case that doesn't seem all that different from the one involving Ethanex.

Below is the original complaint, followed by the most recent, which is the third amended complaint. I think that it's interesting to read both of them, so that you can get an idea for how the case has progressed. As an interesting side note, there have been "clawback" issues related to the case which has made for some interesting discussions and references in other lawsuits. This said, the defendant is being represented by Wachtell, Lipton, Rosen & Katz, which also has a reputation for being effective and a lawyer at the firm even invented the poison pill... Not exactly something that gives a whole lot of comfort.



Both sides have motioned for summary jedgement and responded to each other. There is some pretty interesting and steamy stuff in the various court documents. Zehil had a love interest in the office who set up some of the entities he used to commit fraud and she even used her 5th amendment rights in her testimony... In fact, one of the lawyers at McGuire Woods apparently suspected that Zehil wasn't even admitted to the bar in Florida during the time that he practiced- for something like 5 years! He even mentioned this to him over wine on numerous occasions. Tons of juicy stuff.

If one is betting on this lawsuit, rather than the solvent estate, the question is this: is a law firm liable for the acts of its employees? Should the company have to make a payout when it's acts/it's employees acts were the cause of a company declaring bankruptcy, because said acts not only starved it of needed capital, but also kept it from acquiring the assets it needed to make money in the future? Also, how does one value those loses, pegging an actual amount? Wouldn't this be easier for both sides to just settle on before a trial, avoiding all these unknowns?

As always, time will tell...

Disclosure/Disclaimer:  I own and represent shares of Ethanex. I reserve the right to change the positions at any time. This post is my nothing more than my thoughts/opinion. Always do a ton of your own research before so much as contemplating anything that I say, do, write, or even think about.

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