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Hidden Risk at VirnetX?

The story of VirnetX is like so many battleground stocks: The bulls hang on every piece of apparent good news and the bulls attempt to pierce it with logic and fact.

VirnetX
Source: virnetx.com
VirnetX

With a market value of nearly $2 billion, VirnetX is a virtually zero revenue, profitless bet on a patent payoff at some point in the future. It was created through a reverse merger in 2007. As of the end of last year it had 13 employees.

To summarize the story — and I stress, summarize:

The bulls believe VirnetX is setting itself up to be the next Qualcomm with patents, acquired from SAIC , which control secure communications between 4G mobile devices. An analyst at Cowen is in print saying he believes the patents could be valued more than $3 billion.

Fresh from a $200 million settlement with Microsoft in 2010, the company has sued a number of companies, notably Apple and Cisco .

Adding to the story's sizzle: Bulls like to point out that CEO Kendall Larsen hasn’t sold a share of his 9.5 million share, or 18.8 percent stake, even as the stock skyrocketed from a few dollars in 2007 to highs of around $40. (Contrast that with chief scientific officer Robert Short, who has been an active seller since creating a so-called 10b5-1 sales plan in May 2011.)

Bears, meanwhile, believe that based on almost any other patent case, in any settlement VirnetX is likely to get a fraction of what the bulls expect — assuming it wins any or all of its suits.

And given the murky, complex and convoluted world of patent law, the results can take years. Even then there is no guarantee of a victory, as anybody betting on Eastman Kodak winning its imaging-patent dispute with Apple and Research in Motion just learned.

But as is the case with all patent plays, the stocks ride the wave of hype and hope until proven otherwise.

Consider, for example, in May VirnetX won a one-time payment patent settlement with Aastra Technologies, followed by another win in July against Mitel .

On news of the back-to-back wins, the company’s market value ballooned by roughly $865 million, even though terms weren’t disclosed — suggesting the amount is not material.

Then, on Friday VirnetX’s shares tumbled 9.3 percent on more than double the normal average volume after the Cowen analyst suggested in a note to clients that there had been an unexpected setback in the company’s complaint with the International Trade Commission against Apple. (To my point: There is no straight line or absolutes in patent cases.)

Enter what I like to call the hidden risk. When investors say that CEO Larsen hasn’t sold a share, there’s a reason: According to the company’s proxies for the last two years, of his 9.5 million shares, “7,853,192 shares of our Common Stock pledged to a third party as collateral security for certain obligations.”

In other words, Larsen hasn’t sold because it appears he can’t. While details haven’t been disclosed, such a pledge often suggest the shares have been used for some kind of loan. Further details on Larsen's pledge were not revealed in the filings.

Although I did reach Larsen this morning, he was busy with another phone call and said he would return my call if he has anything to add to this story. Earlier efforts to reach a spokesperson for the company were unsuccessful.

The risk for investors is any kind of event that causes the stock to plunge low enough (whatever level that may be) to trigger a margin call. In a margin call, an investor who margined the shares either has to put up more cash or sell the shares in what amounts to a fire sale — putting further pressure on the stock.

Investors in Green Mountain Coffee Roasters learned about margin calls the hard way recently when Chairman Robert Stiller had to quickly unload most of his 10.6 percent Green Mountain stake.

Turns out, as he had disclosed in proxies, he had pledged 12.5 million of his 15.5 million Green Mountain shares to various third parties. After the company announced bad news, causing its stock to collapse, he sold most of it to meet a margin call, further pressuring the stock. After trading at all-time highs earlier this year, Green Mountain is currently trading at multi-year lows.

Could the same thing happen at VirnetX? It's unclear, but in the very least: It's certainly something VirnetX investors should keep in mind.

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

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