By Elizabeth Dilts, Benjamin Lesser, Carl O’Donnell and Michael Erman
NEW YORK (Reuters)
Last August, National Securities Corp analyst Jonathan Aschoff was bullish on Avenue Therapeutics Inc, a fledgling biotechnology company with no revenue and one drug in clinical trials. In a research note posted on National’s website, he rated the newly listed stock a “buy” and predicted that the share price would more than double in a year
Nearly a year later, Avenue shares are down 36 percent, at about $4.
A few months earlier, Aschoff had waxed equally optimistic about another biotech venture, Checkpoint Therapeutics Inc , with several cancer drugs in various stages of development. He predicted the share price would rise from $10.75 to $18 in a year. It is now around $2.60.
Then in September, he recommended Mustang Bio Inc , which is working on a drug to treat brain cancer. He forecast a 12-month increase in the share price from around $12 to $21. That stock is now at $6.62.
What Aschoff did not mention in any of these bullish notes: His employer, National Securities, is owned by the same company that controls Avenue, Checkpoint and Mustang. That company is Fortress Biotech Inc , the brainchild of longtime biotech entrepreneurs Dr Lindsay Rosenwald and Michael Weiss.
In September 2016, Fortress acquired a controlling stake in National Securities’ parent, National Holdings Corp . The deal solidified an unusual relationship that dates to 2010, when Rosenwald and Weiss, through an investment fund they control, invested $3 million in National Holdings.
Owning National gives Fortress an in-house underwriter and a private sales force of about 700 brokers – nearly a third of whom have been flagged by regulators – to help it raise money for its stable of nine ventures that are developing new drugs or treatments.
If this setup seems like a conflict of interest, that’s because it is one: National brokers are required under U.S. regulations to ensure that they promote investments deemed appropriate for their clients – the same clients to whom they are marketing securities in their parent company’s ventures in biotech, a notoriously high-risk sector.
“I’ve never seen a firm that needs to raise a lot of capital acquire a brokerage for that purpose,” said Benjamin Edwards, an associate professor of securities law at the University of Nevada, Las Vegas, echoing nearly a dozen other experts in corporate finance and securities law whom Reuters interviewed for this article.
Since coming under Fortress’s umbrella, National brokers, with an assist from analysts like Aschoff, have helped raise at least $240 million from thousands of individual investors across the United States to fund Fortress or its related biotech companies, according to data from National. And U.S. Securities and Exchange Commission (SEC) filings show that Fortress-related deals are in the works to raise as much as an additional $125 million.
OUT IN THE OPEN
While Aschoff did not disclose the relationship in the analyst notes, National discloses the conflict of interest in prospectuses for securities offerings it underwrites for Fortress, in keeping with U.S. regulations.
The Financial Industry Regulatory Authority (FINRA), the watchdog funded by the industry it monitors, approved National’s application for ownership change when Fortress acquired it, as required under U.S. regulations. FINRA declined to answer questions about the deal, saying it does not discuss specific firms.
The SEC did not respond to requests for comment. The agency asked Avenue for greater disclosure of its connection to National in the lead up to the biotech firm’s initial public offering last year, but ultimately allowed it to raise money through the investment firm, filings show.
Still, “naïve investors may not even know the connection. Most small investors don’t read the prospectus,” said Roni Michaely, a professor of finance at Cornell University. “If you are selling your own company, you want to sell it at the highest possible price. This is a situation that is very troublesome. … Personally, I wouldn’t touch (the offerings) with a 9-foot pole.”
In an interview with Reuters, Weiss, executive vice chairman of Fortress, said: “We over-disclose. We tell everything. We are the most honest management team ever to walk through this biotech business.” Weiss served as chairman of the National Holdings board from shortly after Fortress acquired a controlling stake in the company until he resigned in June.
A National executive acknowledged on Dec. 4, 2017, that Aschoff’s research notes did not disclose the relationships between Fortress and its cash-raising subsidiaries on one hand and National on the other
In an email Weiss forwarded to Reuters, the executive said National republished the notes in September last year to correct the omission.
However, the notes as they appeared on National’s website in December did not contain such company-specific disclosures. The notes have since been removed from the site.
National on June 5 this year denied that the notes ever lacked proper disclosure, pointing to nonspecific boilerplate language in them that says: “One or more directors, officers, and/or employees of NSC (National Securities Corp) and its affiliated companies, or independent contractors affiliated with NSC may be a director of the issuer of the securities mentioned herein.”
Even with that general disclosure, “it does not eliminate the conflict of interest,” said Michael McMillan, director of ethics education at the CFA Institute
In most cases, a firm will suspend analyst coverage of a company if a potential conflict of interest arises between the firm and the covered company, McMillan said. Fortress’s ownership of National, he said, raises questions about the ability of its analysts to remain independent and objective.
On May 15, more than a year and a half after Fortress acquired its controlling interest in National – and as Reuters continued to make inquiries about the relationship – National posted on its website a page titled “Meet our Majority Shareholder, Fortress Biotech.”
In a section on potential conflicts of interest, National says it and Fortress “have built a unique model that inherently aligns Fortress’ business objectives with the financial interest of National’s clients.” The company says it is “proud” of the Fortress-affiliated deals it has handled since the acquisition. It notes that those are a fraction of the total of $2.835 billion in deals National has closed during the same period.
BROKERS WITH A PAST
In June 2017, Reuters reported that 35 percent of National’s brokers – more than three times the industry average – had a history of regulatory run-ins, legal disputes or personal financial difficulties that must be disclosed to investors under FINRA rules, based on a Reuters analysis of the regulator’s data. A fresh analysis encompassing disclosures from 2000 through June 2018 found that the proportion still hovered at 30 percent.
National executives said the Reuters analysis did not adequately reflect efforts to implement “a new culture at National” – an effort that has included removing 298 brokers since shortly after Fortress bought the company. National also questioned the value of including regulatory disclosures from more than a decade ago, and it pointed out that the firm itself hasn’t been hit with any regulatory sanctions since 2015.
“We’ve worked so hard at changing the culture,” said Michael Mullen, National Holdings’ chief executive officer and a longtime business associate of Rosenwald.
In 2002, FINRA accused analyst Aschoff of falsely claiming to be a medical doctor to obtain inside information about a drug development program at an unidentified publicly traded company. Aschoff, working for B. Riley FBR Inc at the time, agreed to a $10,000 fine and a two-week suspension without admitting or denying wrongdoing.
In a statement provided by National, Aschoff acknowledged the incident and declined to comment on it further
A former National broker told Reuters he learned he was raising money for the National parent’s biotech ventures only after several months of recruiting investors for Mustang Bio. When he asked his supervisor about potential conflicts, he said, “I was told to stop asking questions and get back to dialing.”
Weiss said he found “it hard to believe that there is a broker at National who … did not read anything in the prospectus that says that Fortress has a majority interest in National.” He said National brokers recruited mostly accredited investors – individuals who under U.S. law meet certain minimum wealth requirements – for Fortress deals.
National brokers, Weiss said, sell Fortress deals because the investments make money for brokers and clients alike.
For outside investors, Fortress’s ventures not only carry the typical risks of a long-shot biotech bet; they also come with unique conditions that can put outsiders at a disadvantage relative to the parent company.
For one thing, the upside potential for outside investors is damped by covenants between Fortress and its offshoots that favor Fortress with equity awards over time.
Fortress also treats the cost of acquiring drug-development rights as debt owed by its startups, and that debt is repaid from money raised from sales of the startups’ shares. Fortress ventures have paid at least $5 million under such arrangements across two deals, SEC filings show. The amounts may seem small, biotech analysts and investors said, but they allow Fortress to shift costs onto outside investors.
“It’s a very sweet deal for Fortress,” said Erik Gordon, a professor at University of Michigan’s Ross School of Business. “I think someone could see it as either very smart or very tricky.”
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