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UPDATE: Council 'betrayed' by penny-stock exchange funding scheme

David Grimaldi questions DBOT funding

(More in my column in the Dec. 6 Philadelphia Inquirer here). Nov. 30, with updates: "It's an abuse of power," New Castle County Councilman Penrose Hollins, D-Wilmington, tells me, about the way Delaware's second-most-powerful elected official pumped $3 million in public funds into a mysterious Wilmington stock-exchange proposal. "I feel betrayed."

Hollins last summer sponsored a bill supporting a Delaware Board of Trade penny-stock exchange -- backed, promoters said, by ex NYSE boss Dick Grasso and ex PHLX chair John Wallace and Wall Street prominenti -- in hopes it will somehow bring high-paid finance jobs to the beleagured corporate capital city (that's Wilmington). The proposal included a $15 million private-revenue muni-bond approval -- plus oral promises from DBOT leaders and elected County Executive Tom Gordon's administration that the exchange wouldn't cost any public money.

But on Monday, Gordon announced Council members had agreed "to reach a consensus in support" of his plan to invest $3 million in county park maintenance endowment funds (the Garstin Trust) into private DBOT securities, with the proposed exchange's software systems serving as collateral. But since Council had actually voted ot oppose the plan, Gordon's approach was "very heavy handed," Hollins told me this morning.

Gordon said the bonds have been valued by an outside economist and the project has financing from a national bank -- both of which his office has declined to identify. Turns out Council wants proof that support really exists. "We do not have enough information," Hollins told me.

As I noted in this space earlier (see below), software is difficult collateral. "Generally, in my experience it's tough to use software (code) as direct collateral," says Charles Robins, investment banker at Fairmount Partners in Philadelphia. "There are specialty firms that help providers of software-as-a-service companies by lending against their long-term recurring-revenue contracts." But that doesn't work at companies with no revenues. And if a debtor stops paying, it's a lot harder for a creditor to acquire and sell software code to cover the loss, than it would likely be with a real estate-backed deal, for example.

Securities backed by intellectual property "seem a bit afield of what I would consider appropriate investments," especially given the limits on "allowable investments" for typical government accounts, said Alan Schankel, municipal finance managing director at Janney Montgomery Scott in Philadelphia.

"It's really hard to value software. Can you assign the rights" and find a buyer? asked Chris Annas, president of Malvern-based Meridian Bank. "Even if it's working, who'll do the maintenance? You're one entrepreneur away from someone coming up with something better" and destroying the collateral's value.

Hollins said Gordon's claim his move enjoyed Council approval "was a fabrication of nonsense. Council voted not to appropriate any public funds for the DBOT. There were 10 votes against and 3 not voting" at a council meeting last week. "There were no votes in favor of providing public funds."

Can't Gordon invest them anyway? He says he has that authority. "I don't believe he does," said Hollins. "Council's attorney asked that legal question of the county solicitor. Those questions have not been answered.

"We're trying to bring clarity," he added. "The executive can't pick up the phone and call people and then say he has a consensus. In my opinion he's making a mockery of the process." Hollins' comments were expanded by Council President Chris Bullock and Council members Janet Kilpatrick, John Cartier and Lisa Diller in a statement. Kilpatrick is a member of council's Republican minority; the others are Democrats, like Gordon.

EARLIER: David Grimaldi, recently-fired chief administrative officer of New Castle County, where most of the people in Delaware live, is repudiating his former boss's plan to invest $3 million in park endowment funds in a proposed new penny-stock exchange, with the investment guaranteed by the as-yet unopened exchange's software.

"You were the first reporter to properly cover the nonsensical collateral structure," Grimaldi told me last night. "Although I put the [Delaware Board of Trade] deal together," in concert with county council leaders, the deal as Gordon announced it Monday "was not our idea or proposal," he told me. "We actually had much more favorable terms on the table." But after Grimaldi was fired in October, "the proposed safety nets were removed and the expected return was nearly halved. I also believe that they've grossly misrepresented the risk of this investment to the public and to Council."

Grimaldi says he was moved to write after county economic development and policy chief Marcus Henry, in a News Journal story last month, said there was "a heck of a lot less risk" investing in DBOT bonds, compared to  stocks. Here's the note Grimaldi sent County Council President Chris Bullock and other Council members:

"With all due respect to Mr. Henry, his above mentioned statement is untrue, misleading, and greatly understates the risks associated with the newly revised proposal to invest $3 million in the DBOT deal.

"While it is generally accepted that debt securities are less risky than equities, all things being equal, such a comparison is not applicable in this scenario. It is, indeed, far riskier to move from a diversified basket of publicly traded equities to a single, illiquid, unrated and undercollateralized debt security. (Emphasis added)

"Although DBOT will be managed by some of the most seasoned and well regarded names in global finance, it is important to remember that this venture is a startup. The probability that a new, startup business will survive its fifth year, when the DBOT bond matures, is less than 50%. Because the probability of default is elevated, and even probable, it is crucial to have necessary safeguards in place.

"Our original proposal, discussed with many members of Council, would have provided significant protection by requiring the establishment and maintenance of a reserve account of $4 million, so that both our principle and interest would be secure. Only the Garstin fund would have had any claim to this reserve account.

"The new proposal removes this crucial credit enhancement and replaces it with a pledge of technological and intangible assets, which may have little or no liquidation value. In short, the proposal shifted from one which was overcollateralized and safe to one which is undercollateralized and extremely risky.

"It also appears that the new proposal not only increased the risk to the Garstin fund but also reduced its expected return.

"The original proposal called for annual debt service payments of $180,000 per year and, upon redemption, the repayment of $3 million principle plus a 25% ($750,000) premium payment. The new proposal make no mention of the premium payment and would reduce the internal rate of return to the Garstin Fund from over 10% to 6%.

"While I continue to believe in the vast economic benefits of the DBOT project, which will be managed by some of my professional heroes, I have serious concerns in the "watering down" of the deal structure which took place immediately after my departure, which is contrary to the public interest.

"I believe it would be a grave mistake to proceed with this new structure and strongly urge the reconsideration of the original proposal as I believe that this drastic change, which is to the detriment of the Garstin [park maintenance endowment] Fund, may be a breach of fiduciary duty.

"Respectfully, David Grimaldi" 

 NOTE: The name of New Castle County Chairman Chris Bullock has been corrected.