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 https://www.reuters.com/investigates/special-report/usa-finra-brokers 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."
Weiss and Rosenwald acknowledged the unusual nature of the equity awards, but said that by pricing stock offerings at low valuations, they mitigate the impact of the dilution. In addition, they said, many investors don't plan to hold the stock long enough for the dilution to hit them very hard.
Rosenwald and Weiss together owned 30.5 percent of Fortress as of March 31. For the past three years combined, each was paid $1.6 million in Fortress-related compensation and $5.6 million in stock awards, according to SEC filings.
As for National, its investment banking revenue surged more than 25 percent to $44.6 million in fiscal 2017 from a year earlier, thanks in part to fees from Fortress-related offerings, according to a Reuters review of SEC filings. And National’s brokerage operation collects commissions on Fortress-related shares sold to investors.
"Retail investors need more protections than institutional investors,” and the complex structures of Fortress deals “do the opposite of that," said Les Funtleyder, a portfolio manager at E Squared Capital Management. "That's compounded by the fact that biotech, because it’s so risky, isn't really appropriate for retail investors to begin with."
In an interview, Rosenwald argued that "if anybody thinks that Fortress is getting too good of a deal from the (subsidiary) companies … then you can go out and buy Fortress stock." Those shares are down 35 percent, at $2.25, since April 2015, when publicly listed Coronado Biosciences, a failed venture, was renamed Fortress and became an incubator for Rosenwald and Weiss biotech ventures.
The structure of Fortress's deals, Rosenwald said, doesn't eliminate all risk for the parent company and its executives. Fortress covers overhead costs for its ventures, he noted, including office space, management, human resources and legal advice, amounting to millions of dollars a year. Some of that, however, is repaid to Fortress through fees charged to each company. Fortress said it holds $30 million in direct investments in the ventures, and Rosenwald is an Avenue investor.
However, the biggest risk for Fortress "is reputational," Rosenwald said. "You're allowed to fail in biotech. If they all fail, that's horrible."
Failure is common in biotech. Lead times are long. Startups burn through cash and usually have no revenue. Treatments that show early promise can blow up in late-stage trials. Nine times out of 10, according to a 2016 study by a group of biotech industry organizations, ventures do not achieve the ultimate goal: U.S. Food and Drug Administration approval of a new drug or therapy.
But while payoff is rare, it can be huge. That's why the sector typically attracts venture capital funds and other "smart money" investors who are willing to take on more risk than most.
Over the past two decades, Rosenwald and Weiss have, together and separately, launched more than 50 separate biotech firms. Most of their ventures have conformed to the industry norm, failing to receive FDA approval.
They've had rare successes, too, such as Cougar Biotechnology Inc, which was developing prostate cancer drug Zytiga when Johnson & Johnson bought the company for $1 billion in 2009. The purchase price represented a 16 percent premium to the company's market value at the time. Zytiga received FDA approval in 2011.
Whether a venture succeeds or fails, Fortress has found a way to boost the benefit and trim the risk for itself relative to the retail investors who help fund its ventures. That innovation was on display recently with Avenue Therapeutics.
In 2015, Fortress, then still known as Coronado Biosciences, created Avenue to develop for the U.S. market an intravenous formulation of the synthetic opioid Tramadol to treat pain in patients after surgery. The drug is already sold worldwide in oral form, and outside the United States for intravenous use.
Avenue, with no revenue and only the one drug in its pipeline, went public last summer. Fortress hired Oppenheimer & Co as lead underwriter for the IPO – a role that includes conducting due diligence on the deal and the issuing company. In an unusual move, two-thirds of the Avenue shares offered were allotted to National.
"The deal from the beginning was designed to be a National-led transaction for our clients," Weiss said. "We hired Oppenheimer … to satisfy the regulatory requirements."
Oppenheimer declined to comment.
The IPO raised nearly $38 million. That was already much less than the $50 million Fortress had initially hoped to raise, according to SEC filings.
Avenue soon afterward paid out $6.6 million, or 17 percent of the IPO proceeds. More than $3 million went to cover Fortress's debt from buying the rights to IV Tramadol. The rest repaid a line of credit that Fortress had provided to Avenue.
With that debt repaid, outside investors are now bearing most of the cost of developing IV Tramadol and carrying the most risk if Avenue fails.
Typically, biotech companies hold little debt, if any, when going public so that shareholders are protected from undue risk if the company struggles to bring its product to market, several biotech investors told Reuters.
For Fortress, debt is part of the formula. "We are using debt as Fortress's balance sheet grows. We prefer not to," Rosenwald said. "We will probably stop using debt soon."
Further, the founders agreement between Fortress and Avenue gives the parent company the equivalent of 2.5 percent of Avenue's outstanding shares each year, plus additional shares equal to 2.5 percent of any equity or debt financing.
That provision would benefit Fortress, relative to outside investors, should Avenue succeed and the shares take off. Over, say, 15 years, the annual transfer alone would dilute the value of outside investors' holdings in Avenue by nearly a third.
Rosenwald told Reuters that over such a 15-year span, he and Weiss would "add so much value to these companies that the little bit that keeps us interested financially will be a decimal point."
Avenue's Tramadol formulation is now in late-stage clinical trials, and the company expects to apply for FDA approval by the end of 2019.
"I have never seen a structure like this one before," said Funtleyder, the E Squared portfolio manager. "We would need a really good reason to participate in something like that and probably wouldn't on principle because there are so many other investments that don't have this kind of baggage."
The founders agreement also calls for Avenue to send Fortress 4.5 percent of net sales each year, if Avenue begins producing revenue.
The annual 2.5 percent equity transfer is contained in the founders agreements between Fortress and nine ventures, according to SEC filings.
One of them is Checkpoint Therapeutics, whose shares began trading on Nasdaq last June, just after Aschoff published his "buy" recommendation. Another is Mustang Bio, whose shares began trading on Nasdaq in August last year.
Mustang is in the early stages of developing several immunotherapy products to treat cancer. In a July 2017 appearance on the Fox TV network morning show "Fox & Friends," Rosenwald and Mustang's CEO talked about the potential of one of those drugs to help U.S. Senator John McCain, who had recently been diagnosed with a lethal brain cancer.
"It's early clinical trials," Rosenwald said during the broadcast. "We have to prove the effectiveness."
A year ago, National completed a private placement of Mustang shares, raising $95 million, according to SEC filings. National's fee came to 10 percent, or $9.5 million. An additional $2 million paid Fortress's debt from licensing fees.
Caelum Biosciences, another company with the same founders agreement, is in the early stages of developing a treatment for a rare immune-system disorder called amyloidosis. National raised $9.9 million for the company through the sale of convertible notes to around 170 investors, earning nearly $1 million in commissions, SEC filings show.
ALL IN THE FAMILY
In 1987, Rosenwald, who holds a medical degree from Temple University, started working at D.H. Blair & Co, a Wall Street boiler room that a New York state judge likened to a criminal enterprise and that was led for decades by Rosenwald's father-in-law, J. Morton "Morty" Davis.
In 2000, several executives and employees were charged in New York state court with 173 counts of securities fraud, among other violations. Two years later, the firm and three officers, including two of Rosenwald's brothers-in-law, pleaded guilty to and were convicted of three counts of violating state securities law. (One brother-in-law served time in prison; the other got probation.) Neither Rosenwald nor Davis was charged.
Rosenwald had already left to launch his own small brokerage, Paramount BioCapital, in 1991, he said. Weiss came on board in 1994. Paramount functioned much as National does now, raising money for Rosenwald startups in biotech.
In 2009, FINRA records show, the regulator determined that in two deals for Rosenwald-controlled biotech companies, Paramount had failed to meet the requirement that it hire an independent underwriter "to protect investors from purchasing shares at an unfair price." FINRA also found that Paramount had failed to obtain approval to issue initial public offerings.
Paramount paid a fine of $20,000, without admitting wrongdoing.
Rosenwald said that the people involved "are no longer working with us," and that the violations were "minor technical infractions" not worth fighting.
The following year, Opus Point Partners, an investment fund controlled by Rosenwald and Weiss, invested $3 million in National. Opus and National then formed OPN Capital Markets, a boutique investment bank focused on the healthcare industry. Rosenwald shuttered Paramount.
National took up where Paramount left off, handling a private placement and later serving as co-lead underwriter for the IPO of Ventrus BioSciences, a Rosenwald venture that was developing treatments for gastrointestinal ailments.
A month after the December 2010 IPO, National analyst Jason Kolbert published a research report with an enthusiastic "buy" recommendation. "Bet the horse, bet the jockey!" he wrote. The report did not disclose the connection between National, Rosenwald and Ventrus.
Kolbert did not respond to requests for comment.
Representatives for National and Fortress pointed out that the note included boilerplate language stating: "One or more directors, officers, and/or employees of NSC and its affiliated companies, or independent contractors affiliated with NSC may be a director of the issuer of the securities mentioned herein."
Ventrus raised $65 million through the private placement, IPO and several follow-on offerings. Over the next two years, Ventrus's stock rose from a $6 initial offering price to as high as $21 as investors awaited news on the hemorrhoid ointment, the anal fissure cream and the incontinence gel the company was developing.
As underwriter, National – including its many brokers with FINRA flags – was key to promoting the shares. In one case Reuters found, 17 separate purchases of Ventrus stock were among 38 unauthorized trades a National broker made on a single client’s account between May 24 and July 26, 2012, according to the complaint filed by FINRA. The broker, Glenn McDowell, was permanently barred from the securities business. National fired McDowell in January 2013.
Reuters was unable to locate McDowell.
On June 25, 2012, Ventrus announced that it would abandon development of what had been its most promising product – the hemorrhoid ointment – after it failed its final clinical trial. The share price plunged more than 50 percent in a day. In February 2014, the anal fissure cream failed a key clinical trial, and the stock plunged 63 percent.
A few months later, Ventrus merged with Assembly Biosciences, a small biotech with no ties to Fortress.
Though Rosenwald said he "lost millions" on Ventrus, he, Weiss and other National executives described Ventrus as a success because investors who got out of the stock at the right time made a profit.
(Edited by Brian Thevenot, Lauren Tara LaCapra and John Blanton)