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Could The End of Toxic Convertible Notes Be in Sight?

Updated: Aug 7, 2021

It may happen soon, especially in states like New York, Florida and Texas, all of which have criminal usury statutes capping the amount of interest a lender can charge on a loan. Even for those public companies that have toxic convertible debt whose documents claim that Nevada or Virginia law controls, you may now just be in luck. (Both of those states do not have usury statutes capping interest rates, but that may not matter in some cases). In a recent decision by a federal court in New York, a judge found a few interesting things.

One issue is that the Federal Courts have inconsistent results in applying New York State Usury laws. In an opinion written by Judge Cathy Seibel in the case Madden v Midland Funding, LLC, No. 11-cv-8149, (S.D.N.Y. Feb. 27, 2017), the court noted that “as a federal court applying state law, [I am] generally obliged to follow the state law decisions of state intermediary appellate courts”. The decision specifically requires the federal courts to apply the decisions and law, as decided by the New York State courts, both at the initial and appellate state court levels. The state courts are more understanding of the complexity of

NY’s usury laws, especially in business loan contexts. But still, some federal court judges (and some state court judges) sitting in NY still get it wrong.

In a recent case Union Capital, LLC v. Vape Holdings, Inc. No. 16-cv-1343 (S.D.N.Y. Mar. 31, 2017.), the “daily penalty payments” ($250/$500 day) and “make-whole” provisions were thrown out as being unconscionable and unenforceable penalties that violate New York’s public policy. I expect that this will be the standard the courts use moving forward. This is good news for small cap companies – so go look at your loan documents right now - I am SURE that you have similar penalties and make-whole provisions in your agreements, especially from those lenders located in NY. The note holders always threaten enforcement and start claiming HUGE numbers based on those provisions. By way of example, I have one case where the remaining principal on a convertible note is $12,750.00, yet the note holder is trying to squeeze $200K+ from the company. It’s highly unlikely that they will prevail in court based on the recent decisions.

In the Midland case, the federal court found that notwithstanding other federal court rulings, that “default Interest” is also subject to the NY state usury laws. Most notes include a default interest rate of 24% (seemingly just under the usury cap). However, if you paid other fees, such as legal fees, due diligence fee’s, etc…. those charges may also apply to interest, hence increasing the effective interest rate way above 25%. This decision draws closer to the line of NY state court decisions holding that ALL charges incurred by the borrower, at the time the loan is made, go towards calculating interest for usury purposes.

Interestingly enough, the Union court missed the biggest legal issue; the value of the conversion feature given up by the borrower at the time the loan was given further demonstrating that the federal courts in NY are just not totally there yet. The court used the wrong analysis, looking at the conversion feature as an option with no value, rather than conforming to the line of cases such as Hillair Capital, 963 F. Supp. 2d at 339 (finding value of stock grants should be included in interest rate computation) and Bridge Information Systems, Inc., 311 B.R. 781, 792 (Bankr. E.D. Miss. 2004) (Finding that convertible notes were “hybrid financial instruments” containing both an unsecured debt and an option component that should be valued separately). These cases stand for value of stock grants, options (which IS the conversion feature of your notes) and warrants all must be considered in interest calculations for usury purposes. The Bridge case further indicates that the conversion feature itself has a specific value, apart from the unsecured loan, and should be counted towards any interest calculations). And if you are a CEO or CFO of a public company, you KNOW that GAAP and the IRC requires you to value the conversion feature separately from the note at the time the loan was made, further supporting the Bridge decision that the conversion value is separate and must be accounted for separately. That one aspect of the convertible note (ranging from 25% to 60% discounts) is sometimes all that you need to cross the criminal usury threshold in New York, Florida and Texas, as well as several others.

But we have another important issue to focus on for those companies whose documents claim controlling law in Nevada or Virginia. In the Midland case, the judge also found that a choice of law clause providing for another states laws to control the agreement alone is insufficient to displace NY law. The caveat is that the lender or the borrower must have some other connection to the forum of choice other than a mere recitation of a choice of law provision. This is important because there are no less than 40 toxic convertible note lenders in New York, and many of you CEO’s have loans with them. If they try to sue you in NY, and claim another states laws control (one without a usury cap), Midland at least forces that NY court to examine the contacts with that other state to determine whether to apply NY law, not the law of the state contracted for, because NY has a strong and overriding public policy to enforce its own usury laws when an action is brought in NY. This isn’t a slam dunk, because a lot of small cap companies are Nevada companies, and if your documents claim Nevada law, and the suit is brought in NY to enforce the note, the mere fact that Nevada is the state of incorporation may defeat that argument.

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