Red Flags at Typhoon Touch Technologies

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Larry Harris
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The current primary business of Typhoon Touch Technologies (OTC:TYTT) is the management of two closely related patents involving the application of touch screen technologies to portable computing devices. The Company bought these patents in June 2007 for $350,000 plus 10% of any licensing fees that they can collect. The patents, which were first filed on July 28, 1993 and October 4, 1994, essentially say that placing a touch screen in a portable computing device would make the device more useful. The patents expire in 2013 and 2014.

The Company is now aggressively suing the manufacturers of laptop, cell phone, and PDA devices to enforce its patents. Their strategy has been to target small producers first and then go after the Apples and Dells of the world. Two small producers have settled for small money, presumably to avoid the nuisance costs of litigating. Apple (AAPL), Dell (DELL) and other similar firms probably will not settle without a substantial fight, and they could very likely prevail.

I expect their defense will be that there was already was “prior art,” i.e., that someone had already put a touch screen into a portable computer. Alternatively, they may argue that the invention at the time of the filling would have been obvious to “a person having ordinary skill in the art.”

Certainly the obvious argument is quite strong: Touch screens were put into desktop machines to make the machines easier to use. Everyone then knew that computers were made as desktops and as portable machines, and that portable machines had been attempts to replicate the functionality of desktops. Thus, it would have appeared obvious at the time that touch screens also would be placed into portable machines.

The targeted firms may also argue that the patents are not enforceable because no serious efforts had been made to enforce them for more than ten years, even though touch screens were being placed in a wide variety of portable computerized devices throughout this period.

(See here for a discussion of the importance of novelty and non-obviousness for a patent.)

The Company recently completed several unusual transactions that suggest that the insiders do not think that their patents will stand.

The CEO Sold All His Shares

On July 1, James Shepard, the founder and CEO of the Company, sold his 58% ownership in the Company back to the Company in exchange for assets that appear to be worth less than $64,805, and probably nothing at all. He received the TYTT music business, the original business of the company: A project to create kiosks in shopping centers at which customers could download music files to their MP3 devices. The $64,805 represents the book value of the project, which apparently is not anywhere near completion.

You can read about this transaction in the April 29, 2008 SEC Form 14 Proxy statement here. See especially “Determination of Sale Price” at the bottom of page 13. Note that the text there indicates that the directors of the firm believe that “the actual value of our shares of common stock is probably much less than the last trade price”, which was then $3.50, which is equivalent to $0.035 following the 100:1 forward split.

One would think that as CEO, Shepard would know better than anyone else the value of the patents. Why did he sell his position? This transaction suggests that he does not think that the patents were valuable.

Alternatively, the transaction may have been prearranged as a condition for the transfer of the Company to others unknown in consideration for a consulting contract of $5,000/month plus 2% of the net profits on the patents. If so, the Company has a serious SEC reporting problem. Something here does not make sense.

The Investors Gave Up 100% to Get 40%

Following the CEO Shepard’s sale of his 58% ownership of the Company back to the Company, the remaining shareholders then owned 100% of the common stock. Almost all of these shareholders acquired the stock two years ago through a private offering in which they purchased units consisting of one share and one warrant to purchase an additional share at 2.5 cents.

Late in June, the other shareholders—all of whom are accredited shareholders—then proceeded to convert 99.4% of the outstanding common shares into new Series A preferred stock. The preferred stock is entitled to only 40 percent of the net profits of the firm.

Why did they do this?

Perhaps because the preferred shares have a liquidation preference of 10 dollars per share: If the Company is liquidated for any reason, the preferred shareholders will get 10 dollars per preferred share before the common shareholders get anything.

Since the accredited investors converted at a rate of 10 pre-split common shares to one preferred share, the liquidation protection that they got was equivalent to only 1 dollar per pre-split common share. Following the 100:1 split, this protection is equivalent to only one cent per post-split share. It would appear that the accredited investors do not expect much profit because they exchanged ownership of almost 100% of the profits for ownership of only 40% of the profits to get this protection.

What do they know that we don’t?

Alternatively, perhaps the insiders took the 40% because they believed that new financings necessary to fund the Company’s litigation efforts would dilute their 100% share to substantially less than 40%. If so, current common stockholders should be very concerned. The conversion of the former common shares to preferred shares will require that even more common shares be issued to fund the litigation than would have been necessary had the former shareholders not sought the protection of the preferred stock. The common stock thus may be diluted substantially.

(You can read about these transactions in the Proxy filing cited above and in the SEC Form 8-K Current filing here.)

The Initial Investors Did Not Exercise Their Deep-in-the-Money Warrants

On May 18, the initial investors allowed all 26,080,000 of their warrants to buy an equal number of pre-split common stock shares at 2.5 cents per share to expire worthless. At that time, the stock had last traded at $3.50 (before the 100:1 forward split) and a bid was in the market at $4.50.

Why didn’t they exercise these warrants? They could have paid only $652,000 in aggregate to double their investment in the Company. Perhaps they thought that further investment would be foolish.

Alternatively, perhaps they collectively realized that with Shepard selling, they would already own 100% of the firm so that further investment would not increase their share. The problem with this argument is that each individual investor should have exercised to increase his or her share relative to other investors and to avoid the dilution that would result when the others exercised. The fact that no one exercised suggests that they were acting in concert. In which case, this would represent a serious SEC reporting problem since the collective control was not disclosed in an SEC filing, as it should have been.

(Note that the Company's SEC filings to date do not explicitly indicate that the warrants were not exercised. However, this information can be implied from the number of common shares outstanding before the above transactions (62,080,000), the number sold by CEO Shepard (36,000,000), and the number converted by the shareholders (25,933,500) to preferred stock. The remaining number of common shares (146,500) were then split 100 to 1 yielding the current number of common shares outstanding as reported on the above Form 8-K (14,650,000). Thus the warrants apparently were not exercised.)

Summary

The CEO and other investors in Typhoon Touch Technologies have engaged in some very strange transactions that appear quite inconsistent a belief that the patents are valuable. The strangeness of these transactions also suggests SEC reporting problems.

The stock did not trade from February 15 until late June, at which time prices skyrocketed as the few shorts in the stock got squeezed when essentially all the common stock was converted to preferred stock. These recent prices reflected the squeeze and not the value of the patents. If the patents prove to be worthless, so will the common stock.

It is hard to understand why investors should buy stock at anywhere near the current bid of $5 when just a few weeks ago, accredited investors who have held the stock and have known the Company for two years chose not to buy more stock at $0.00025 per post-split share.

Disclosure: Author holds a short position in TYTT.OB

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Larry Harris profile picture
14 Followers
Larry Harris holds the Fred V. Keenan Chair in Finance at the USC (http://www.usc.edu/) Marshall School of Business (http://www.marshall.usc.edu/). His research, teaching, and consulting address trading and investment management issues that arise in financial markets. He has written extensively about trading rules, transaction costs, index markets, and market regulation. His introduction to the economics of trading, TRADING AND EXCHANGES: Market Microstructure for Practitioners (http://tradingandexchanges.com/) (Oxford University Press: 2003), is widely regarded as a “must read” for entrants into the securities industry. Chairman Harvey Pitt appointed Dr. Harris to serve as Chief Economist of the U.S. Securities and Exchange Commission (http://www.sec.gov/) in July 2002 where he continued to serve under Chairman William Donaldson through June 2004. As Chief Economist, Harris was the primary advisor to the Commission on all economic issues. He contributed extensively to the development of regulations implementing Sarbanes-Oxley, to the resolution of the mutual fund timing crisis, to the specification of the proposed Regulation NMS (National Market System), and to numerous legal cases. Harris also directed the SEC Office of Economic Analysis (http://www.sec.gov/about/economic.shtml) Interactive Brokers, Inc (http://www.interactivebrokers.com/). (IBKR) and of Clipper Fund, Inc. (http://www.clipperfund.com/) (CFIMX), as the director of the USC Marshall School Center for Investment Studies, and as the research coordinator of the Institute for Quantitative Research in Finance (The Q-Group (http://www.q-group.org/)). In the past, he has served as an associate editor of the Journal of Finance, the Review of Financial Studies, and the Journal of Financial and Quantitative Analysis. Other professional service has included year-long assignments to the U.S. Securities and Exchange Commission and to the New York Stock Exchange immediately following the Stock Market Crash of 1987. Dr. Harris has also worked at UNX, Inc., an electronic pure agency institutional equity broker, and at Madison Tyler, LLC, a broker-dealer engaged in electronic proprietary trading in various markets. The University of Chicago awarded Dr. Harris his Ph.D. in Economics in 1982.

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