The case of the disappearing stock

NEW YORK (Fortune) -- When does buying a stock not mean buying a stock? When the company decides that the shares can't actually be delivered to the buyer.

A few weeks ago, some would-be investors in a small pharmaceutical company called Adams Respiratory Therapeutics, (Charts) which makes the Mucinex brand of mucus-busting products, learned this hard lesson. They thought that they'd bought shares in a secondary offering that the company did early in the week of March 12.

But that Friday morning, March 16, Morgan Stanley (Charts), which underwrote the offering, called the buyers to tell them that they weren't getting their shares after all. The buyers weren't out the money they'd paid for the shares, but the situation caused upheaval nonetheless.

Those who had bought, say, 100,000 shares, and then sold that stock in a quick trade, found themselves with an unexpected short position. Those who thought they were long Adams Respiratory found out they weren't.

What can cause such a thing? This particular saga has some deep roots. The story began back in 2001, when venture capital fund Perseus-Soros Biopharmaceutical Fund, which is a venture between the Washington, D.C. based Perseus and George Soros's Soros Fund Management, began acquiring a 25% stake in Adams. Two of Adams' board members were Perseus-Soros employees: Steven Elms, who would become chairman of the board in October 2005, and Andrew Schiff (husband of Karenna Gore Schiff.)

In July 2005, Adams went public, and Perseus-Soros sold 1.3 million shares at $17 apiece. The stock did spectacularly, and the fund sold more shares in a secondary offering in December 2005, at $43.75 per share. In 2006, Perseus-Soros began exiting its position in earnest. In August, Adams filed a prospectus which registered another 10 million shares for sale, including Perseus-Soros's 3.4 million remaining shares. In September, Perseus-Soros sold 1.5 million of those shares at $39 apiece. In June 2006, Schiff stepped off the board, and in October Elms announced that he would not stand for re-election at the company's annual meeting that December.

Fast-forward to March 2007. On Monday night, March 12, Morgan Stanley priced the sale of Perseus-Soros's remaining 1.2 million shares at $37.75 per share. (The roughly 600,000 shares belonging to Perseus-Soros that aren't accounted for were likely sold in overallotments, which is when the seller agrees to provide additional shares in the event that the offering is oversubscribed.) On Tuesday morning, would-be buyers were notified of their purchases. On Wednesday morning, Adams filed a prospectus supplement regarding the sale with the SEC.

But Friday morning, purchasers of the shares began getting calls from Morgan Stanley, informing them that they would not be getting their stock after all. Later that afternoon, Adams put out a press release that its results would fall short of Wall Street's expectations, and that a promising new drug had not done well in clinical trials. The last line of the press release read as follows: "Additionally, the Company announced today the termination of an underwriting agreement it had executed in connection with its existing re-sale registration statement. The pending trade in connection with this underwriting agreement has been cancelled." Adams' stock plummeted 25% to $28.22.

There is no more public information about the cancellation, and some investors say they've never heard of such a thing. "All I can tell you is that it's a cancellation," says an SEC spokesman.

Experts agree that the events at Adams are very rare, but both Morgan Stanley and Adams were abiding by securities laws. In this type of transaction, there are a number of conditions that a company must meet for the sale to settle. One of the typical conditions is that the company have a "clean" prospectus. If the company's prospects change, then the prospectus is no longer accurate. And so Janet Barth, the head of investor relations at Adams, says that the company had no choice but to cancel the trade. Barth also notes that the liability for the trade belongs to Adams. In other words, if the sale had gone through and the bad news had come out the following week, Adams would have to defend itself against investor complaints.

What about those who thought that they had purchased stock? Many may be relieved, given the big drop. But in general, it's caveat emptor. According to securities laws, if shares are sold that are not already in the public float - which was the case here - then the buyer bears the risk that the trade won't settle. (Settlement is supposed to be three days after the purchase date.)

In other words, someone who thought she was getting stock and sold that stock ahead of settlement is stuck with her resulting short position. (This is only the case for "new issuance," or stock that hasn't been in the public float before. If you buy shares on an exchange like the NYSE, you have a contractual right to those shares from the moment of purchase.)

And there is at least one instance of this happening before. Back in 1983, a company called Eagle Computer went public. The day of the IPO, the company's president was killed in a crash of his new Ferrari. The underwriters reversed the IPO. Although Eagle did eventually go public, the company eventually suffered the fate of so many other computer upstarts.

As for Perseus-Soros, presumably, even though Elms only left the Adams board in December, the fund didn't know that Adams' operations were about to undergo a turn for the worse. That's because even though Adams bore the liability for the sale, it would still be against the law for Perseus-Soros to try to trade on inside information. (Perseus-Soros did not return calls for comment.) Adams stock has since rebounded to about $36 a share, but it's an open question whether Perseus-Soros or other shareholders will ever be able to sell at a price as high as $37.75 again. As the old saying goes, timing is everything.