Hudson Bay IP Opportunities Fund, managed by Yoav Roth, is locked in a bitter dispute over the conversion of warrants issued by Worlds Inc. in three private placements of convertible debt that the patent monetization company considers “death-spiral” financing.

Brookline, Mass.-based Worlds is a technology-based company with a portfolio of patents for multi-user interactive technology. In particular, Worlds owns the rights to nine patents for inventions that provide highly scalable architecture for a three-dimensional graphical, multi-user, interactive world system. Worlds is engaged in active litigation against Activision Blizzard Inc. and related companies in an infringement case filed in U.S. District Court for the District of Massachusetts.

In September, Hudson Bay IP Opportunities fund, which is a unit of Hudson Bay Capital Management, run by Sander Gerber,  filed a lawsuit against Worlds in New York Supreme Court asserting that the Hudson Bay IP Opportunities Fund is entitled to a significant downward adjustment of the exercise price of the warrants because of a decision by Worlds board to substantially extend the term of 7.5 million stock options held by CEO Thom Kidrin.

The downward adjustment known as a full-ratchet anti-dilution provision means that if Hudson Bay was entitled to purchase 100 shares at a $1 and Worlds issued stock at 50 cents, then Hudson Bay was entitled to reset the price of its warrants to 50 cents and receive 200 shares instead.

“Without justification or cause, Worlds has refused to honor its obligations under this warrant, thereby diluting the value of the warrant to Hudson Bay's detriment,” the fund's complaint says.

Hudson Bay is seeking money damages of $914,876 and the turnover of 4.95 million common shares, as well as attorney fees and a preliminary injunction with respect to the shares.

New York-based Hudson Bay declined to comment for this article.

The dispute has its roots in a series of convertible debt and warrant PIPEs that Worlds issued to Hudson Bay IP Opportunities Fund, Iroquois Capital LP and GRQ Consultants in March 2013.

Hudson Bay IP Opportunity received a warrant to purchase 2.17 million shares of common stock of Worlds at 50 cents a share subject to a full-ratchet downward adjustment anti-dilution protection.

During the time period relevant to the dispute, Worlds stock has traded between 13 cents and 54 cents.

Although New York-based Iroquois and Boca Raton-based GRQ Consultants, which is run by microcap financier Barry Honig, invested in the same PIPEs, neither Iroquois nor GRQ have joined Hudson Bay IP Opportunities Funds' suit.

Honig said he hasn’t joined the suit because he’s "a different kind of investor than Hudson Bay and less interested in structure" like warrants that effectively guarantee a return.

To be sure, he conceded that if Hudson Bay prevails in the dispute he stands to make money because his warrants will have to be adjusted downward as well.

“I think both sides should consider a settlement because otherwise the only ones who win are the lawyers.”

Josh Silverman, manager of Iroquois, declined to comment.

For his part, Kidrin said in an interview that Worlds doesn’t believe that options originally given to him seven years ago can trigger the anti-dilution provisions cited by Hudson Bay.

“It’s just Hudson Bay doing what Hudson Bay does,” he said.

Moreover, Kidrin said in an interview that Hudson Bay's suit is predicated on a error the company made in its securities filing regarding a mistakenly included alternative option extension, which was never in force.

In an Oct. 14 filing with the Securities and Exchange Commission, Worlds said it previously reported that in January 2014 it extended the term of 7.5 million stock options granted to Kidrin from March 31, 2014 to March 31, 2016.

“We have now learned that this disclosure was incorrect inasmuch as the approval of the extension was premised on the erroneous supposition that Mr. Kidrin’s options were only 18 month options and were expiring on March 31, 2014, when in fact they were five (5) year options expiring in September 2017.

“The options in question were granted pursuant to the terms of Mr. Kidrin’s Employment Agreement dated as of August 30, 2012, which was filed as Exhibit 10.2 to our Annual Report on Form 10-K for the ended December 31, 2012, which clearly states that the options had a term of five (5) years.

The company said it reported in the Form 10-K for the year ended December 31, 2012 and in subsequent periods that Kidrin’s options were for an eighteen-month period, which was predicated on the execution of an option agreement of similar term.

“We inadvertently executed two versions of an option agreement in March 2013, one having a five-year term based upon the terms contained in the Employment Agreement and one having an eighteen month term based upon an earlier proposal by the board without realizing that there were two versions.”

As a result, although the five-year version was maintained in the company’s files, it “erroneously provided only the eighteen-month version to our independent auditor and prepared our financial statements and disclosures based upon an eighteen-month option term for Mr. Kidrin. We continued to erroneously rely on the wrong document until September 2014” when Hudson Bay cited the 18-month version in its suit.

Kidrin played down the mistake, saying it changed nothing and blaming it on the fact that Worlds is run by only one full-time employee, himself, and a part time CFO. He also stressed that, otherwise, Worlds’ compliance with regulatory filings has been exemplary compared with Pink Sheet companies that never meet their filing requirements.

He added that shareholders haven’t expressed concern about the mistake because it didn’t affect them at all. He said the options were cashless and hurt nobody but himself in that he agreed to give up half his options for the good of the company’s future prospects.

Kidrin owns about 6.8 million shares of Worlds, which is equivalent to about a 5% stake.

Jack Hogoboom, a partner with the law firm of Lowenstein Sandler PC in Roseland, N.J., said he would hate to be in the company’s shoes having made such an error.

“Hudson Bay is very aggressive,” Hogoboom said. “I would call it a coin flip.”

Hudson Bay’s argument may hinge on whether it can prove it suffered damages, which may be difficult given the erroneous inclusion of the 18-month extension, he said.

But that may not matter if Hudson Bay can prove it made its investment based on the erroneous information in the first place, and wouldn’t have done so under the actual circumstances, he said.

In an affidavit filed with the New York Supreme Court, Kidrin explained that the dispute stems from 15 million stock options which exercised at 5 cents and were granted to him in 2007 as part of his compensation.

In June 2012, with his options about to expire Kidrin said he began negotiations with the company about the terms of his employment and compensation going forward.

"Taking into account the company's financial condition and the need for additional work, including litigation (the Patent Lawsuit), that needed to be completed before the company would commence earning revenue, I was willing to continue serving as CEO on substantially the same terms, but with a lower base salary.

"In or about early August 2012, in consideration for my not exercising my 15 million options, which would have significantly limited the company's ability to raise additional funds through an equity sale and diluted the then current shareholders, the board proposed to issue me the 7.5 million options at $0.076 per share for 18 months. This offer was made prior to the renewal agreement, which was still being negotiated.”

In late August or early September 2012, Worlds’ board revised its position and instead offered Kidrin a 5-year employment contract to expire Aug. 30, 2017.

Among other things the contract granted Kidrin the option to purchase 7.5 million shares of Worlds common stock at the 7.6 cent price for 5 years ending Aug. 30, 2017. This was only half the 15 million shares he was originally to receive.

In August, 2012, Kidrin was introduced by Chris Marlett, the CEO of IP focused investment bank MDB Capital Group in Dallas to Hudson Bay's Yoav Roth and its in-house IP counsel Richard Allison. He said he was told that Hudson Bay funded Vringo Inc., which had been a publicly traded ringtone company before it merged with a privately held patent monetization company.

Marlett said in an email he didn’t remember Kidrin and doubts he would have introduced him to Hudson Bay unless Worlds had few other options.

Kidrin said in the affidavit he was told that Hudson Bay "had expertise and a large investor following in the IP litigation area, and that it was the best company of those participating in the IP funding arena."

In addition, Kidrin said he was told Hudson Bay was interested in investing in Worlds and helping to back its patent litigation strategy.

In order to persuade Hudson Bay to invest in Worlds and back its litigation against Activision Blizzard, Kidrin said the company agreed to allow Allison to conduct due diligence on the company, its patents and the patent litigation.

Moreover, on Nov. 6, 2012, the company entered into a consulting agreement with Hudson Bay and Iroquois Capital giving them 750,000 shares of common stock then valued at $135,000. The stock was worth 18 cents at the time.

Kidrin said although Hudson Bay said the due diligence would take six weeks, the process extended for four months.

During that time, Worlds stock increased in value from 17 cents to 42 cents and more than doubled the value of the shares given to Hudson Bay and Iroquois to $315,000.

"The increase in price was unrelated to Hudson Bay's due diligence, or any potential investment; rather, it had to do with the anticipation for the Markman hearing, which was then placed on the patent lawsuit's court's calendar for June 2013.

After that, on March 14, 2013, Worlds entered into a securities purchase agreement with Hudson Bay and similar purchase agreements with Iroquois Master Fund and GRQ Consultants Inc. 401(k). The aggregate amount of the three agreements was $2.45 million, of which Hudson Bay provided $1.1 million.

Hudson Bay, Iroquois and GRQ have invested together or separately in a number of companies in the patent monetization business, including Vringo, Spherix Inc., and Marathon Patent Group.

The agreement with Hudson Bay, Iroquois and GRQ also required Worlds to hold $2 million of the money raised "in a lockbox account that Worlds could not access without the consent of the investors."

This severely restricted Kidrin's ability to manage Worlds and its lawsuit against Activision Blizzard.

"The reason the company agreed to this two-tiered conversion structure is that the Markman hearing in the patent lawsuit was originally scheduled for June 22, 2013, and it was anticipated by all parties that the market price of Worlds common stock would increase significantly as the Markman hearing date approached in anticipation of a positive outcome, and increase again following the hearing," Kidrin said in his affidavit.

This proved a faulty assumption, however, when the judge in the case, Judge Denise Casper, was assigned to the criminal case of James "Whitey" Bulger, which began the same day the Markman hearing had been scheduled.

As a result of the Bulger trial, Worlds eagerly awaited Markman hearing was delayed for more than a year until Oct. 3, 2014.

After the hearing was rescheduled, Worlds' stock price began to decline from 54 cents to 26 cents due to selling on the OTC market.

Kidrin said in his affidavit that he believed the stock also fell because a significant short position developed.

"Worlds was thus compelled to renegotiate the notes, because it could not risk the triggering of a 'death spiral,' which could be caused, among other reasons, by the investors (among others) short selling Worlds’ common stock, which would depress the market price, thus allowing the investors to convert at a much lower price, reaping a windfall when the price returned to equilibrium, to the detriment of the company’s other shareholders, who would find their holdings both diluted and devalued.”

Kidrin further charged in his affidavit that Hudson Bay "participated, directly or indirectly in the creation of a 'death spiral' in the summer of 2013, causing significant decrease in the market price of Worlds' common stock from $.54 to $.26 per share."

Furthermore, Kidrin alleged that Hudson Bay has shown the propensity for such conduct by "having subsequently settled allegations of illegal short selling brought by the SEC by entering into a consent decree with the SEC as of September 16, 2013, in administrative proceeding file number 3-15478.”

According to the Securities and Exchange Commission’s administrative proceeding in September 2013, on four occasions, from May 2009 through December 2012, Hudson Bay bought offered shares from an underwriter or broker or dealer participating in a follow-on public offering after having sold short the same security during the restricted period. These violations collectively resulted in profits of $665,674.96.

Hudson Bay, which has assets under management of $2.9 billion, was accused of illegally shorting shares of MGIC Investments, American International Group and Wells Fargo ahead of follow-on offerings.

The firm was ordered to disgorge $665,674.96 in profits, prejudgment interest of $11,661.31 and a civil money penalty in the amount of $272,118 for a total of $949,454.27.

“I think Hudson Bay just in hot water with the SEC would be willing to talk with him,” MDB Capital’s Marlett said.

Kidrin said in an attempt to salvage shareholder value and break free of the death spiral, the company entered into an amendment and exchange agreement dated July 15, 2013 whereby all the funds in the lockbox would be returned to Hudson Bay and others unused.

In return for cancellation of the notes, Worlds agreed to give the investors an aggregate of 7 million shares of common stock worth $2.31 million. of those shares, Hudson Bay received 3.35 million shares worth $1.1 million.

"From March 14, 2013 through July 15, 2013, Hudson Bay received a windfall of approximately $891,250 for its initial $215,625 outlay, a return of 400% for a fully-secured 4 month loan, or a 1,200% annualized return, in addition to the $67,500 of value it received as its portion of the shares distributed in consideration of the initial consulting period during the due diligence period, which had market value of $180,000 when eligible for open market sales under SEC Rule 144.

As part of the exchange agreement, Hudson Bay also received an exchange warrant, which granted it the right to purchase 2.17 million shares of Worlds common stock at an exercise price of $1 for 5 years. The exchange warrant contained the full-ratchet anti-dilution protection at issue in Hudson Bay's suit against Worlds.

Kidrin said in his affidavit that he was keenly aware of the exchange warrant and its full-ratchet downward adjustment and took pains not to do anything to trigger it.

He asserted that the erroneous options extension approved by the board does not even have the force of law because the original 5-year rights he received cannot be superseded by an extension for a shorter time.

Moreover, he said Hudson Bay clearly was aware of the erroneous rights extension but failed to bring it to Worlds attention except in the lawsuit filed in New York Supreme Court.

He said the exchange warrant "prevented Worlds from consummating numerous potential transactions proposed by bankers and IP firms, and effectively prevented Worlds from accessing the capital markets from the summer of 2013 to date....Instead, cognizant of the exchange warrants full-ratchet anti-dilution provision, Worlds has refrained from issuing common stock, and instead has raised funds by borrowing against future revenue at rates approximating a 500% return on investment.”

To reach the reporter responsible for this story contact Dan Lonkevich at 707 318-7899 or dan@thepatentinvestor.com