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It's a Horrible Idea

— In a brazen daylight move -- shielded somewhat by cloudy legalese -- a San Diego biotech company is trying to reduce its current shareholders to near insignificance. But not long after the astonishing corporate moves were announced, stunned shareholders began to communicate via investor Internet chat rooms. Now they hope to block the measures coming to a vote at the company's annual meeting March 18.

The company is Avanir Pharmaceuticals. Unlike almost all biotechs, it actually has a federally approved product on the market. But like almost all biotechs, it has been losing money massively, and its financial future depends on drugs that are still in the development stage.

And that's the rub. Long-suffering shareholders feel double-duped. Management wants to decrease the number of shares outstanding, but at the same time increase the number of shares that can be offered in the future. Existing stockholders fear they would lose out on their share of big profits that management boldly predicts will come from new products.

What particularly galls shareholders is that officers and the board have a tiny stake in the company, collectively owning just 459,000 shares of 71 million that are outstanding.

The company, whose stock sells for under $2, made big news in the late 1990s. It ousted its founder, David H. Katz, as both sides hurled insults at one another in raging court fights. The lawyer representing the company -- then called Lidak -- even asked the jury if Katz was a lunatic. But, alarmed by this year's stock-dilution attempts, Katz has re-emerged to speak up for shareholders.

In late January, Avanir sent out its proxy statement for the March 18 meeting. The company proposed that shareholders vote for a reverse stock split. In such a move, an owner of ten shares, say, turns them in and gets one back. In theory, the stock price should also move up by a factor of ten, although it often doesn't happen. Reverse splits are a sign of woe. Avanir says it wants one to raise the stock price so it can attract large institutional investors -- another thing annoying small investors. Then the company wants authority to issue another 100 million shares.

Avanir is seeking authority to reverse-split the shares anywhere from 1-for-2 to 1-for-12.5. The proxy spells out that if the split is 1-for-12.5 (the worst-case scenario), the number of common shares would be reduced from 71 million to a mere 5.7 million. The company already has authority to issue about 100 million shares. If it gets permission to peddle 100 million more, around 200 million additional shares could be pushed out the door, swamping the 5.7 million, say irate shareholders.

The proxy admits that the added shares could be used by management to "delay or prevent changes in control or changes in or removal of management, including transactions that are favored by a majority of the shareholders." (Italics mine). The newly issued shares could go to management-friendly hands, admits the proxy. Talk about a free pass...

Jim McBride of Key Largo, Florida, is steaming about "management's outrageous requests." He has organized investors to fight. He says that if the company gets its way, retail investors (basically small investors), who now control 90 percent of the stock, could own less than 3 percent. Investors representing more than 5 percent of outstanding shares -- the legal threshold -- have given McBride authorization to demand a shareholder list from the company, which says it will cooperate. He will urge all investors to thumb down the proposals.

"I thought they [Avanir] had a fiduciary duty to me," says Peter Govorchin of Okemos, Michigan. "The shareholders that will benefit from the reverse split are shareholders in the distant future. It's a horrible idea."

Along with other shareholders, he is also upset about two deals within the past year in which the company issued 12 million shares at a low price to private investors. "They keep doing preferential deals with sharks," says Govorchin, noting that current investors' interests are diluted even more by such transactions.

He believes the opponents already have half the votes needed to defeat the proposals.

Avanir's moves would "emasculate existing shareholders -- render us powerless," says Dudley Bowlby of Madison, Wisconsin, noting that he and his family have about the same amount of stock as the company's chief executive, Gerald J. Yakatan.

Shareholders are hopping mad about the legal wording giving management the right to override shareholder wishes. "It is a legal masterpiece to protect the company from any potential subsequent recourse by anyone -- shareholders, partners," says Katz. "It is despicable -- the most outrageous proposal of shareholder put-it-in-your-face crap I have ever seen."

Investors don't like other things. The company has a successful product, Abreva, for treatment of cold sores, but some complain that Avanir has forfeited too much future cash flow from the product by selling revenue rights to another firm. Avanir feels its real future lies with Neurodex, a treatment for uncontrollable laughing and crying of patients suffering from Lou Gehrig's disease, Alzheimer's, multiple sclerosis, stroke, and the like.

But the proxy reveals that Avanir has an agreement with a company named IriSys to sublicense worldwide rights to Neurodex. And who owns IriSys? Well, none other than Yakatan "is a founder, chairman, and majority shareholder of IriSys," admits the proxy, asserting that IriSys did not get favorable terms in the deal.

"The consensus of shareholders -- and I agree with that consensus -- is that it is a blatant conflict of interest," says Bowlby, who also believes that most retail shareholders would like to see Katz back as chief executive.

Several obvious questions arise. What percentage of IriSys does Yakatan own? If Neurodex is successful, what percentage of proceeds will redound to IriSys?

"It's a private company; it's nobody's business," says Yakatan when asked how many IriSys shares he controls. He won't say how much he paid for his shares but says, "I built that company with my own cash." He says that IriSys will get less than 20 percent of any money to be made in Neurodex.

Katz says that when he was chief executive, Yakatan, then head of clinical drug development, approached him about Neurodex. It was presented to the board. But at the time, Yakatan already had licensed Neurodex and did not reveal it, says Katz, adding, "It was a violation of his employment agreement."

"It is not true," says Yakatan, saying he did not have a financial interest in the product when it was brought to the board. "I hope we can get into a situation where we are in front of a judge, and we will find out what the story is."

As to IriSys being a conflict of interest, Yakatan says, "How can it be a conflict of interest if it is revealed? I am not hiding anything. Those shareholders wouldn't have a company [Avanir] if it weren't for me. I saved that company."

Gregory P. Hanson, Avanir's chief financial officer, believes shareholders are exaggerating how many shares the company would issue. "We are just a small company," he says. "It is an unreasonable assumption that all of these shares would be issued."

Maybe, but this company talks big. Hanson says it has "a wonderful pipeline" of drugs in development. Yakatan says that by the time Neurodex is approved and ready to be sold to patients (probably in 2006), the total market will be half a billion dollars, and there are now no major competitors. The company should get a fair chunk of that half billion, and there are other potential products, too, claims Yakatan.

Believing such statements, many shareholders expect Avanir to grow large -- and that's why they don't want their piece of the pie severely diluted. And several complain that Avanir's board members have questionable track records. For example, chairman James B. Glavin is also chairman of ailing biotech Immune Response, whose cumulative deficit of $292 million is three times Avanir's cumulative deficit. Glavin got in on the Immune Response shares for one-fourth of a cent each, as did other insiders. Another Avanir board member, Dennis J. Carlo, was a cofounder and longtime official of Immune Response. And another Avanir board member is former San Diego mayor Susan Golding. It was during her reign that San Diego got deliberate pension underfunding, the Chargers 60,000-seat guarantee, and the Padres ballpark, which was supposed to pay for itself but will cost almost $20 million annually.

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