Dark Clouds Gather Around CombiMatrix

Aug.28.14 | About: CombiMatrix Corporation (CBMX)

Summary

The largest institutional owners have exited their entire positions.

The company engaged in lawsuit, with potential liabilities equaling 3x its market cap.

The FDA gearing up to regulate its industry.

CombiMatrix (NASDAQ:CBMX) is a small biotech nano-cap specializing in cytogenomic testing for prenatal diagnosis, miscarriage analysis, and pediatric developmental disorders. As a full-scale cytogenetic and cytogenomic laboratory, CombiMatrix offers chromosomal microarray analysis, standard and customized FISH, and high-resolution karyotyping.

In August of 2012, ever since the appointment of new CEO Mark McDonough, the company's fortunes appear to have changed for the better, as it has now experienced back-to-back record quarters, signed numerous partnership agreements, and continues to have more and more health networks and insurers cover the cost of its procedures. On paper, it's all systems go!

You can read about all the good going on at CombiMatrix here:

However, my article is not to focus on the obvious good. Instead, my article if to focus on what no one seems to be talking about... some very large elephants in the room that could very well (and soon) squash shareholders.

Institutions and Insider bailing out

At the start of the year, things were looking great for CBMX. In December, after a 10-for-1 reverse stock split and subsequent capital raise, institutions seemed to find value in the stock. Institutional investor Longwood Capital Partners LLC took a 5.08% position in the company, as indicated in a filing from Jan 03, 2014. Then, Great Point Partners LLC entered the fray with a 9.99% position in the company, as indicated in a filing from Feb 14, 2014. These filings can be seen here. In just a matter of a few months, institutional ownership had rocketed from some very small percentage to over 15%. If you're long any stock, few things are more pleasing than witnessing institutions supporting your holdings. But to see them bull-raiding one of your holdings is even better.

So, where are Longwood and Great Point today? They are completely out. Sadly, the largest institutional holder today is The Vanguard Group with a 1.07% stake, while total institutional ownership sits around 3%. Meanwhile, CBMX stock has fallen over 42% (from $3.50 to $2.00) since traders swarmed into the stock after the TheStreet.com's publication from March 17, which brought in volume 29x its current average (5,066,100 vs. 169,640).

Another person who has recently joined in on the selling of CombiMatrix shares is director (and former CEO) R. Judd Jessup. Mr. Jessup sold 13,679 shares @ $2.00 on Aug 13, only one week after CBMX established a new 52-week low of $1.91. This was the first insider sell of CBMX stock in over seven years (since March of 2007).

Ongoing lawsuit and possible negative judgment could cripple CombiMatrix and squash shareholders

CombiMatrix has been dealing with one particular lawsuit (in one way or another) since November of 2000. Here's a quick summary to get you up to speed on both the history of the lawsuit and the allegations that have been made. The allegations come from Dr. Michael Strathmann. Dr. Strathmann began consulting for CombiMatrix in 1998, and later joined the company in Nov of 2000. Then, in Jan of 2003, CombiMatrix promoted him to VP of Research & Development, a position he held no later than mid-2005 (could not locate the exact date of his resignation).

  • In 1994, a Dr. Donald Montgomery went to work for Nanogen, Inc. (NGEN), a bio-technology company located in San Diego.
  • Dr. Montgomery signed an agreement with NGEN, which provided that any invention conceived by him while at NGEN would belong to NGEN.
  • While employed by NGEN, Dr. Montgomery invented a unique biotechnology process by which chemical compounds were made on an array of electrodes.
  • Dr. Montgomery disclosed his new invention to Brook Anderson, one of Acacia Research Corporation's (NASDAQ:ACTG) founders.
  • ACTG made at least one payment to Dr. Montgomery while he was still employed by NGEN. (*Note: This fact was not discovered until seven years later, in July of 2002).
  • In Aug of 1995, Dr. Montgomery resigned from NGEN.
  • In Oct of 1995, Dr. Montgomery and ACTG founder Brook Anderson formed a new company... CombiMatrix.
  • In Nov of 1995, Dr. Montgomery sued NGEN over the rights to the technology he developed while employed by NGEN.
  • In 1996, Dr. Montgomery and NGEN settled their lawsuit (Feb), Dr. Montgomery became a director of CombiMatrix (Apr), and Dr. Montgomery filed a provisional patent application covering CombiMatrix's core technology (Jul).
  • In Nov of 2000, NGEN filed a lawsuit against Dr. Montgomery and CombiMatrix alleging they had stolen technology owned by NGEN.
  • In Dec of 2000, CombiMatrix notified its insurance company, National Union Fire Insurance Company of Pittsburgh PA (National Union), and made a claim under its corporate liability policy. The policy required National Union to reimburse certain defense cost.
  • National Union acknowledged receipt of the claim but, ultimately, never responded in writing to request for reimbursement.

It's alleged by Dr. Strathmann that when the lawsuit was filed by NGEN, CombiMatrix was in the early stages of licensing its technology to Roche Applied Science (ROG.VX). However, because Roche was concerned whether CombiMatrix had clear title to the technology, Roche required any partnership with CombiMatrix not be effective until it'd obtained a settlement with NGEN.

  • In July of 2002, while preparing for the production of documents to NGEN, CombiMatrix attorneys discovered a check that had been written by ACTG to Dr. Montgomery while still employed by NGEN.
  • In Aug of 2002, CombiMatrix reached an agreement in principle to settle with NGEN.
  • In Sep of 2002, CombiMatrix entered into a final settlement with NGEN. CombiMatrix agreed to pay NGEN cash, stock, and future royalties having a total value of $20.1 million.

In late 2002, Dr. Strathmann alleged that when he asked then CombiMatrix CEO Amit Kumar (CEO Sep 2001 through Apr 2009, and prior to this, VP of Life Sciences for ACTG since Jul 2000) why they'd settled for such a large percentage of stock, Kumar replied that it was because Dr. Montgomery had stolen the technology from NGEN and that a "smoking gun" document (the check written by ACTG to Dr. Montgomery) had been discovered by the lawyers, and if the case did not settle, CombiMatrix would have had to turn this document over to NGEN. He also claims another reason Kumar gave for settling the case was to satisfy Roche.

  • In Nov of 2002, CombiMatrix made a claim with National Union for full reimbursement of the cost of the settlement with NGEN.
  • In Dec of 2002, CombiMatrix merged with Acacia and becomes a wholly-owned subsidiary of ACTG.
  • In Apr of 2005, CombiMatrix and ACTG filed a complaint against National Union for breach of contract and bad faith alleging that they were forced into a settlement with NGEN due to abandonment, mounting legal fees, and the prospect of a lengthy court battle.
  • In Aug of 2007, CombiMatrix was spun off by ACTG through an initial public offering. On Aug 15, CombiMatrix began trading under the symbol "CBMX" on the Nasdaq.
  • In Feb of 2008, the United States District Court for the Central District of California issued a ruling against National Union finding that CBMX's settlement with NGEN was "involuntary and in response to the Defendant's breach of duties" and that "Plaintiffs faced economic ruin and were forced to settle with Nanogen". The court awarded actual damages of nearly $21.5 million, added another $10.3 million in prejudgment interest, and then added another $3.9 million to cover the present value of future royalty payments and attorney fees. Grand total of judgment: nearly $35.7 million in favor of CBMX and ACTG.
  • National Union appealed the judgment, later submitting documents in an attempt to prove that CBMX had settled with NGEN to satisfy Roche, not out of economic necessity.
  • In Jan of 2010, National Union and CBMX/ACTG decided to settle their case. National Union agreed to pay a single lump sum payment of $25 million.

In Feb of 2011, Dr. Strathmann served CBMX with a complaint filed in the Superior Court of Orange County, CA. The complaint alleged that CBMX had submitted false and fraudulent insurance claims to National Union in connection with its settlement with NGEN.

  • In May of 2011, the Superior Court dismissed the complaint and ordered it be stricken for violation of the California anti-SLAPP statute, which prevents plaintiffs from filing abusive lawsuits against public policy.
  • In Jun of 2011, Dr. Strathmann filed a Notice of Appeal with the California Court of Appeals.
  • In Oct of 2012, the California Court of Appeals reversed the Superior Court's dismissal finding that the anti-SLAPP statute was not applicable due to the complaint being protected by the Public Interest Exception of the anti-SLAPP statute... or, more specifically, under subdivision "B" of Insurance Code 1871.7, which states that every person who engages in insurance fraud in violation of Penal Code section 549 or 550 is subject to penalties and assessments. Insurance Code 1871.7 also authorizes any interested person to bring a qui tam action to recover damages and penalties for fraudulent insurance claims both for that person and for the State of California. The person who brings the qui tam action is called the "relator". The relators in these cases do not personally recover damages but, if successful, do receive a substantial percentage of the recovery as a bounty.
  • In Feb of 2014, CBMX filed a Motion for Summary Judgment requesting that the Court enter judgment in CBMX's favor without trial.
  • In Apr of 2014, CBMX's Motion for Summary Judgment was denied on procedural grounds, because its notice of motion and separate statement were both found to be defective.
  • In Jun of 2014, the case of THE PEOPLE ex rel. MICHAEL STRATHMANN, Plaintiff and Appellant vs. ACACIA RESEARCH CORPORATION et al., Defendants and Respondents began being heard.

Specifically, the defendants in this case include ACTG, CBMX, and Amit Kumar. Thus far, ACTG and Amit Kumar have attempted to distance themselves from the accusations. Both have raised their own separate issues, namely, that they are not liable for the actions of CBMX... to which the Plaintiff has disagreed.

So, what's at stake here? Apparently, a lot. CBMX has claimed Dr. Strathmann is not pursuing this lawsuit solely for the public benefit, because "he seeks to personally recover 'at least 40% but not greater than 50% of the proceeds of this action' which could result in an award to Strathmann of between $30 million and $37.5 million."

To state this differently, if CBMX believes Dr. Strathmann could be rewarded $37.5 million at 50%, then we are looking at a total potential liability of $75 million. This figure due to the ability of the courts to reward treble damages (remembering that in 2010, National Union settled for $25 million).

Think about that for a minute. CBMX currently has a market cap of just over $22 million. The potential judgment against it is $75 million. CBMX currently trades at $2/share. Let that sink in.

FDA prepares to regulate the Laboratory Developed Test (LDT) Industry

On July 31 of 2014, the U.S. Food and Drug Administration (FDA) took important steps to ensure that certain tests used by healthcare professionals to help diagnose and treat patients provide accurate, consistent, and reliable results. Consistent with the requirements of the FDA Safety and Innovation Act of 2012 (FDASIA), the FDA has notified Congress of its intention to publish a proposed risk-based oversight framework for LDTs which are designed, manufactured, and used within a single laboratory.

While some might see these actions as coming from an overbearing FDA, the FDA insist that its actions are necessary to demonstrate the agency's commitment to personalized medicine. In taking this action, the FDA demonstrated its agreement with some of the larger biotech companies (namely Genentech, which became a division of Roche in 2009) who had argued that many of their FDA-approved LDT tests were having to unfairly compete against non-FDA approved LDT tests.

A provision in the FDASIA requires that the FDA give Congress at least 60 days' notice before the agency publishes for public comment any draft guidance on the regulation of LDTs. Then eventually, the comment period will commence and also last for 60 days. Finally, a public meeting will be held.

So, while this might not have an immediate impact on shares of CBMX, this could change in 6-12 months as more details come forth from the FDA. Assuming that complying with these new FDA rules will not be too costly or unreasonable, I believe that long-term this could be a positive development for CBMX. However, for now, it just translates into more uncertainty, which is always a negative. CEO Mark McDonough addressed some of this uncertainty during the Q&A session following last quarter's conference call.

In Closing

I believe the risk involved in holding CBMX over the next six months to be excessive. While the company's business is obviously heading the right direction, there are too many immediate headwinds facing investors to justify holding the stock.

For the quarter ending on June 30, 2014, CBMX had a net loss of $2.6 million (of which $860,000 came from litigation expense), while cash, cash equivalents, and short-term investments were down to $10.1 million (vs. $14 million year end 2013). Even with no lawsuit or FDA concerns, I'd expect CBMX to be looking for an additional capital raise (i.e.: more diluting of shares) within 6-9 months. Looking further out onto the horizon, however, I believe the company could become EBITDA-profitable by 2016 Q4 or 2017 Q1, based on its current earnings trends and business prospects.

A $10,000 investment in CBMX 10 years ago is worth $61.50 today. While I certainly don't expect the next 10 years to resemble the prior 10 years, investors should keep the historical perspective in mind until they have a reason to believe the tables have turned for good. With CBMX, those tables won't turn until this lawsuit is (finally) settled and until there is some clarity regarding the ability of the company to comply with new upcoming FDA guidelines. Until then, investing in CBMX will remain a Vegas-like bet, with the odds heavily tilted in favor of the house.

With a market cap of only $22 million, it's not hard to imagine the crippling effect a judgment of a $25 million (very possible) to $75 million (worst-case scenario event... lose trial, treble damages awarded, and the company found to be sole party at fault) could do to CombiMatrix's share price.

To witness what a reversal in fortune in the courts can do, one needs to look no further than the slaughter that took place in Vringo, Inc. (VRNG) shares several weeks ago. The stock fell from a close of $3.15/share to an intraday low of $0.67 the following day, after having a previously awarded $30.5 million judgment reversed.

The day before this judgment was reversed, VRNG has a market cap of $291.5 million. However, the judgment against it brought its market cap all the way down to $62 million at the following day's intraday low. Stated differently, the $30.5 million judgment against it, at one point, caused a reduction in its market cap of $229.5 million. Think about this for a minute. Let it sink in.

Now imagine the carnage that could result if CBMX (with a market cap of only $22 million) has a judgment against it of $25 million, or $50 million, or $75 million. The verdict could be 1x-3x the entire value of the company itself! The risk here cannot be over emphasized. If it loses this case, it's not hard to imagine investors waking up to a possible haircut of 50%-75%.

Additionally, because the company is currently sitting on only $10.1 million in cash/cash equivalents, that fund raising I expected to come anyway within 6-9 months... it would likely need to be fast-tracked. Then what do we have? We'll have fund raising going on while the company is trading at new 52-week lows, heading into the end of the year where tax-loss selling typically peaks. In a nutshell, this court case is a potential time bomb.

So, what happens if the opposite happens and CBMX wins its lawsuit instead? I'd guess the stock could test its old floor (from Jan to mid-May) of $2.70 area. For those doing the math, that's a possible gain of 35% vs. possible losses of 50%-75%... a risk/reward ratio investors should avoid.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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