convertible note dilema

Commiserations to shareholders who have endured the recent falls. I dislike small shareholders losing at the expense of corporate goings-on. Ive reviewed with a view to investing but Imo careful thought is required to estimate a value for RCP, given the position it has negotiated itself into.

La Jolla have an interest in RCP, IRL (both Kiernam), INL, DMG & VLA. They appear to be a private family backed company based in California and their activities in Australia are relatively recent from what I can tell.

In my view, their modus operandi in Australia (despite what their website says) is to offer funding to cash starved operations. They require their convertible notes to be convertible for shares at prices less than current market value. In RCPs case, their activity (IMO, so far) has been to repeatedly convert to cheap new shares and quickly sell on market to realise a margin. Repeat every few weeks and dont worry what the sp is, as long as:

- theyre not holding a large holding when the price falls. They are not, as it is their sell downs or temporary sell-outs that primarily drop the price.
- the sp must to be low enough to attract buyers for the volume of shares they have for sale. This is also a catch 22 situation - the lower the sp the more shares there will be to sell from future conversions, the lower the sp, the more shares

In RCP, their placement of 125m shares would have made La Jolla a substantial holder. So imo the placement and any sell-down would have required substantial shareholder notices. There were none, yet as at 9 March 2010 they appear to have sold this and all their conversions to date, except the last one - http://www.redbankcopper.com.au/investors-and-media/share-information.html shows La Jolla is only holding 38,135,593 shares [2.78%]. These are the shares acquired on their last conversion on 5th March. So the rest, which amount to 191,610,435, have presumably been sold. This is a large number of shares, but unfortunately not compared to the number that could hit the market from future conversions.

The Agreement

I imagine La Jolla carefully reviewed many small spec companies. RCP has good ground, but is cash strapped. La Jolla offers an extra low 4.75% interest rate on an unsecured loan. Extremely low. It no doubt encourages uptake of the offer, but perhaps earning annual interest is not the primary intent.

La Jolla offer to advance US$7.5m (approx A$8.3m). But not in one go. It is drip feed it at US$375k (A$415k) per month, over 20 months from Dec 2009 to July 2011. With their activities so far, this drip feeding means they might be able to advance the US$7.5m with only say US$1m of cash. Converted shares are sold and those funds can be recycled to fund the next instalment of $375k. Drip feeding ensures RCP always has a minimal cash balance, so is always beholding for the next cash fix imo.

While all shareholders approved the following, small holders tend to go along with whatever is presented by the directors. In Dec 2009 the RCP top 20 owned only 36%, so 2/3rds was owned by small holders. Few would sceptically review the proposal or create waves if they had concerns. Directors proposed the following in resolutions:

1/A floor (conversion) price of 1.2c . Trouble is, this is a marketing misnomer IMO and not a floor price at all. A floor price is an absolute limit and cant be breached. This line has been easily breached. In this case its only a level below which the requests by La Jolla to convert (buy) shares, can be cancelled if RCP pays La Jolla 1.5x that particular conversion value - in cash. In reality RCP cant/wont do this as:
- they dont have spare cash
- it would make the directors look incompetent if they needed to go to such an extreme to negate a deal they had just negotiated. This is worst case, but imagine paying US$11.25m to extract yourself from a US$7.5m deal, while never having the cumulative advances totalling $7.5m for long enough to use it in the business.

2/ The option of termination if the sp drops below 1c. Imo this serves two purposes. It tends to lull the signatories into the impression that La Jolla would be unhappy with a low sp. Confusion via smoke and mirrors. Secondly, as well as being addicted to the drip feed, it gives La Jolla the right to withdraw all funding. This is an even greater axe over the companys head, which tends to ensure the company promptly issues shares on each conversion request.

3/ Waiving the usual statutory takeover offer, triggered when any individual shareholding exceeds 20%. This becomes dangerous because of the failed floor price clause. If La Jolla wanted to accumulate, theoretically they could purchase up to 90% without launching a takeover.

4/ While C/Notes are outstanding, neither La Jolla nor its affiliates can short sell, sell put options or similar instruments on RCP ordinary shares. That is good, but critically there is no escrow period on converted shares so this permits their immediate sale.

The overall outcome IMO is that La Jolla has been hellishly successful in manoeuvring the board. Presumably the directors and Kiernan now realise the trap theyve sprung on themselves. La Jolla now sits in a privileged position for the next 22 months.

Possible Future
La Jolla may continually convert their drip feed loan into shares at a 20% discount to the lowest recent trades (being the average of the lowest 3 VWAP days in the preceding 3 weeks). It is/will be, demoralising for shareholders to continually see La Jolla dilute them at sub market prices.

So far La Jolla has converted on average about every 2 weeks. They have purchased 125m shares from a placement and 105m shares from note conversions. The problem for everyone is that they will likely create and buy a further A$7.5m worth of shares over the next 22 months to Dec 2011 at below market prices. For example, at 0.8c per share this would be 940m shares.

Possible La Jolla scoreboard is: (cost & shares issued)

Placement $1.25m 125m
Converted $0.78m 105m (@20% below MV)
Total So Far $2.03m 230m
Bal that could Convert $7.52m 940m (est @ 20% disc to a 1c mv, 0.8c)
New Total Shares on Issue 2,313m (@1c = Mcap of $23m)

Any sort of alternate corporate play is constrained given the pending dilution from the avalanche of convertible notes to convert at cheap but unknown prices.

The share consolidations will reduce everyones shares by 90%, but the impact of La Jolla is still the same. In fact consolidations often have the psychological effect of dropping the theoretical new price by 30% or so. On the other hand, people perceive the price has already dropped a lot (which it has from dilution and then the sale of those new shares but for overall fundamental valuation purposes only the total market cap is relevant).

Kiernan is in the process of being diluted as well. He is constrained by the 3% 6 mthly creep limit (6.1% pa). Not coincidentally, hes just increased his holding of 343.8m by 21.2m (6.17%) to cover the last and next 6 months. No more buying for 6 months now. Over the years MK has been somewhat adept at issuing cheap options/shares. Ironic that he is getting beaten by La Jolla at his own type of game. The small shareholders always take a hiding.

La Jolla might have sold Kiernan his 21.2m @ 1.05c, in which case the rest of their sales (170.4m) look to have been absorbed by small holders - but only at lower prices. Imo this doesnt worry them as they just top up with fresh shares at the low price. La Jollas current strategy is low risk for them. They have converted most of their advanced instalments to shares (at submarket prices) and sold at market prices - returning their original cash and a margin. They are currently holding about 38m shares at a cost to them of 0.59c.

Its hard to see this cycle breaking without a change in the low risk conversion and selling practice by La Jolla. Conversions must finish in 2011. La Jolla could stop prior to that (or converted shares be retained by them), if the price gets to such a level that its just more lucrative to hold longer term as an investment, even allowing for their own future dilution in 2010 and 11.

Finally, to me there seems to be a deficit and timing mismatch between the $8.3m funding organised so far and the costs coming up (the built and installation timing of the modular SX-EW Plant, 2010 drilling costs and the corporate/site admin costs running at $1.1m per ). Mr Kiernan has a history of purchasing new equity to help out in such situations, at a discounted price and maybe free options. Very interested to see if anything like that happens this time, given the unknown final dilution by La Jolla.

Apologies for the winding post. Not investment advice and only my thoughts. Interested in holders opinions.