Damages Exposure from Toxic Death Spiral Convertible Note Dilution Funding Violating SEC Rules, Usury Laws, and Federal RICO Statutes

In the evolving landscape of microcap finance, an increasing number of convertible notes are facing legal challenges under federal securities law, state usury statutes, and the Racketeer Influenced and Corrupt Organizations Act (“RICO”).  When such instruments are found to violate multiple bodies of law—particularly United States Securities and Exchange Commission (“SEC”) underwriting rules, state usury laws, and federal civil RICO—the resulting exposure to civil and potentially criminal damages is significant.  This article examines the likely outcomes and damages flowing from such violations, offering insight into how courts are beginning to treat these hybrid violations.

I. SEC Underwriting Violations: Recession 

Convertible notes that fail to comply with federal securities underwriting requirements are increasingly scrutinized under SEC Rule 144, Section 5 of the Securities and Exchange Act of 1933, and Section 15 of the Securities and Exchange Act of 1934 (the “Act”).  The result is that the convertible notes are void pursuant to §29(b) of the Act.  See Eastside Church of Christ v. National Plan, Inc., 391 F.2d 357 (5th Cir. 1968);  Reg’l Properties, Inc. v. Fin. & Real Estate Consulting Co., 678 F.2d 552 (5th Cir. 1982).  When a noteholder is found to be acting as an unregistered dealer or underwriter—such as by acquiring and converting notes to sell into the market—they may face civil enforcement and private litigation.

Damages Consequences:

• Rescission: The issuer may be entitled to rescind past conversions and recover the fair market value of shares issued in violation.

  
  

Numerous private actions seeking rescission under Section 29(b) for an underlying violation of Section 15(a) have been equally successful.  See Edgepoint Cap. Holdings, LLC v. Apothecare Pharm., LLC, 6 F.4th 50 (1st Cir. 2021);  Berckeley Inv. Group, Ltd. v. Colkitt, 455 F.3d 195 (3d Cir. 2006);  Carebourn Cap., L.P. v. DarkPulse, Inc., No. 27-CV-21-1173, 2023 Minn. Dist. LEXIS 1732 (Hennepin Cnty. Apr. 21, 2023);  More Cap., LLC v. DarkPulse, Inc., No. 27-CV-21-1173, Index No. 390 (Hennepin Cnty. Dec. 11, 2023).

The SEC’s Recent Retreat from Enforcement

The SEC has prosecuted toxic lenders that utilize a business model for unlawfully operating as an unregistered securities broker or dealer, in violation of § 15(a) of the Act.  See e.g., SEC v. Big Apple Consulting USA, Inc., 783 F.3d 786 (11th Cir. 2015);  SEC v. Almagarby, 479 F. Supp. 3d 1266 (S.D. Fla. 2020);  SEC v. Keener, 580 F. Supp. 3d 1272 (S.D. Fla. 2022);  SEC v. Fierro, No. 20-2104, 2023 U.S. Dist. LEXIS 112797 (D.N.J. Dec. 18, 2020);  SEC v. Carebourn Cap., L.P., No. 21-cv-2114, 2023 U.S. Dist. LEXIS 172244 (D. Minn. Sept. 27, 2023);  SEC v. River N. Equity LLC, 415 F. Supp. 3d 853 (N.D. Ill. 2019);  SEC v. Fife, 2021 WL 5998525 (N.D. Ill. Dec. 20, 2021).  

However, in 2024 and early 2025, the SEC began quietly retreating from several of its dealer registration enforcement cases, either dismissing claims voluntarily or failing to pursue further actions after initial setbacks in court.  Some cases stalled following adverse rulings questioning the breadth of the SEC’s “dealer” definition when applied to private lenders engaged in isolated transactions, rather than continuous dealing activity akin to that of traditional broker-dealers.

This development undermines the credibility and momentum of the unregistered dealer registration theory, reducing its viability as a litigation tool for public companies seeking to void convertible note obligations.

Nevertheless, there is no express authority or mandate to date indicating that the SEC’s recent retreat of enforcement of the dealer registration estops a private litigant from seeking rescission under a convertible note for violations of the SEC’s underwriting rules.

Effect on Public Company Challenges to Convertible Notes

1. Weakened Basis for Section 29(b) Claims

Public companies have, in recent years, attempted to use the dealer registration theory as a sword to void toxic convertible notes—arguing that the counterparty’s failure to register as a dealer renders the transaction voidable.  With the SEC now backing away from such claims, courts are less likely to view this argument favorably in private litigation, particularly in the absence of agency support or precedent.

Without a live or settled regulatory position from the SEC, courts may be reluctant to find that routine convertible note financing triggers registration obligations absent “regularity” or “customer-facing” activity typical of a dealer.  This is especially true in light of decisions such as SEC v. Keener, 580 F.Supp. 3d 1272 (S.D. Fla. 2023), which emphasized the totality of circumstances in assessing dealer status and rejected bright-line rules.  See Id. at 1285.

2. Increased Burden on Issuers to Prove Illegality

If the SEC is no longer prosecuting these cases, the burden shifts to issuers to independently establish that their lenders acted as unregistered dealers in violation of the Exchange Act. This requires extensive factual development, expert testimony, and a costly litigation process, making it a less attractive or feasible strategy for many small-cap companies.

3. Encouragement of Private Market Normalization

The SEC’s retreat could also embolden convertible note financiers, who may feel vindicated by the absence of active regulatory oversight.  As a result, public companies may see an increase in the prevalence of highly dilutive financing arrangements with limited legal recourse under federal securities laws, particularly where usury or state-law theories are unavailable.

II. State Usury Laws: Voiding Notes and Return of Principal

Damages Consequences:

• Void Instrument: The entire note, including principal and interest, is rendered void and unenforceable.

• Return of Payments: The issuer may recover all amounts paid under the usurious note, that may include the market value of all stock used to retire the debt by the toxic lender.

• Declaratory Judgment: Courts may issue a declaratory judgment voiding the instrument, preventing further enforcement.

  
  

Cases like Adar Bays, LLC v. GeneSYS ID, Inc., 179 N.E.3d 612 (N.Y. 2021)., affirmed that usurious convertible notes—even those issued to sophisticated parties—are void from inception under New York law.

III. RICO Violations: Treble Damages and Attorney Fees

Where a pattern of predicate acts exists—such as the systematic collection of an unlawful debt, plaintiffs may assert civil RICO claims under 18 U.S.C. § 1962.

Unlawful debt is any debt that violates state usury limitations on the interest rate allowed by state law. The RICO threshold is 50%, or double that of the state usury law limits. In New York, criminal usury is any charge of interest above 25%. For a federal RICO claim, the amount charged needs to be more than 50%. This is almost always the case with convertible notes that charge anywhere between 30% and 50% conversion discounts.

Damages Consequences:

• Treble Damages: RICO provides for three times the amount of actual damages sustained.

• Attorney’s Fees and Costs: Prevailing plaintiffs are entitled to recover legal fees and expenses.

• Joint and Several Liability: All participants in the RICO enterprise can be held jointly liable.

  
  

Recent decisions, such as DarkPulse, Inc. v. EMA Financial, LLC, 2023 U.S. Dist. LEXIS 33994, at 1 (S.D.N.Y. Mar. 1, 2023) and VNUE, Inc. v. LG Capital Funding, LLC, 2024 U.S. Dist. LEXIS 58931, at 1 (E.D.N.Y., Mar. 30, 2024), suggests that federal courts are increasingly receptive to RICO theories where there is a coherent pattern of unlawful convertible note practices.

Combined Violations: Stacking Damages and Strategic Leverage

When an issuer alleges violations across multiple axes—securities laws, usury statutes, and RICO—the damages not only stack but reinforce the availability of remedies.  For example:

• A usurious note may be voided and rescinded;  

• Attorney’s fees and costs are paid to the prevailing plaintiffs;  and

• The broader scheme may qualify for treble damages under RICO.

  
  

Hypothetical Damage Example:

• Principal advanced: $200,000;

• Total shares converted and sold: $1.5 million;

• Usury voids the note: $0 balance owed;

• SEC violations lead to rescission of $1.5 million stock value;

• RICO treble damages on $1.3 million in losses = $3.9 million;

• Attorneys’ fees and costs: $250,000;  and

• Total exposure: Over $5.65 million.

Conclusion: A High-Risk Financing Strategy Ripe for Litigation

Convertible note financing can be a double-edged sword.  For issuers, challenging toxic notes through securities law, usury, and RICO claims offers a roadmap to meaningful recovery.  For investors and lenders, aggressive enforcement of such notes—especially without regulatory compliance—poses significant legal and financial peril.  As courts clarify these overlapping liabilities, the trend is unmistakable: hybrid violations involving convertible notes are no longer insulated from serious financial and punitive consequences.

Litigants and counsel should proceed with caution—and opportunity—in this new era of accountability.

If you or your company has entered into a convertible note and want to explore the convertible note’s legality, including possible remedies in the event of a violation, contact Christopher M. Basile, Esq. at The Basile Law Firm P.C., at (516)-455-1500 x115 or email Christopher at chris@thebasilelawfirm.com.