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Is A Convertible Note a Security?

Updated: Nov 11, 2021

Convertible Note Stock may NOT be eligible for Resale after 6 months but may also be subject to state Usury Laws.

The deadly toxic convertible note – lenders praise them, OTC Market issuers, public audit firms, accountants, securities attorneys, CEO’s and shareholders despise them. Why?  Because 9 times out of 10 it’s the mere existence of these financial instruments that sends quality investment bankers and shareholders alike running for the hills and away from severe dilution. 

Recently, two of the biggest OTC stock clearing houses, COR CLEARING and ALPINE have made it near impossible to clear stock that is the product of a convertible note. (Alpine announced that starting April 13th–last Friday ,that it will place severe restrictions and costs on clearing such stock). For the last several years a handful of lenders from New York, Massachusetts, Florida, Chicago and Texas have figured out a way to get back up to 10 times the money they loaned to underfunded microcap companies by issuing loans in exchange for small, short term notes that can be converted into stock at discounts exceeding 30% to the issuers trading market price. Many unsuspecting or otherwise desperate CEO’s of microcap companies use these short-term financings to plug and correct short-term cash flow issues to pay for payroll, regulatory filings, professional fees, etc….. These loans are usually one-offs between a single lender and the issuer. These notes are not tradable on any public market or platform as no public market exists to trade these notes and day traders and other types of investors would obviously not look at these notes as investments because as soon as the lender can sell the stock, they do. When agreeing to issue these notes, the issuer is not going out to the public to solicit investment, rather, 99.9% of the time, it's either word of mouth referrals or some independent investment bankers helps to arrange these loans.

So how are these notes “securities” making resale of the underlying stock eligible pursuant an exemption under Rule 144? Do the documents say they are?  Did you just decided to not question this and go along with the toxic debt program? Well, they may not be securities, no matter how much the lenders or their opinion-writing attorneys scream that they are.  You see, the SEC includes in its definition of a security a “convertible note”, but there are several caveats that CEO’s and their company’s securities attorneys should be aware of. The Notes are only “presumed” to be securities under the statute, and in reality, a large percentage of them may not be.  Why is this important? Only a restricted security can be sold in the public market pursuant to an exemption under Rule 144 if the “security” has been held for more than 6 months and then only based on a detailed opinion and supporting documents provided by the lenders broker and attorney when submitting a conversion notice. So lenders are attempting to tack back from the date the note is issued so in 6 months the lender can compel the issuer to issue them stock to be sold under the Rule 144 exemption, sometimes call “free trading” stock. Sorry for the rudimentary analysis, but almost everyone reading this understands how this works.

However, go back and read the second paragraph of this article again and you will see that I offered a set of facts common to almost all issuers of convertible notes, on the how's and why's these note are issued. That means when the lender requests a conversion of a note based on those facts the lender may only be entitled to receive restricted securities and then wait 6 months more before an opinion can be submitted to release the restriction on resale.

Here’s the law:

A toxic convertible note may not meet the definition of a “security” under the test established by the United States Supreme Court in Reves v. Ernst & Young, 494 U.S. 56, 110 S. Ct. 945 (1990) as well as in the federal court for the Southern District of New York in New Earthshell Corp. v. Jobookit Holdings Ltd, No. 14-CV-3602 (JMF), 2015 U.S. Dist. LEXIS 27141 (S.D.N.Y. Mar. 4, 2015). In Reves, the Court applied four factors in determining whether a note is a security: 

(1) The motivations that would prompt a reasonable buyer and seller to enter into the transaction.The courts look at the purpose of the money and how it is to be used by the borrower focusing in on whether the funds are used for short-term cash issues or are to be used for a business purpose such as purchasing machinery and inventory. The courts here are looking for an actual investment into the success of the company longer term than just the note. 

(2) The court examines the plan of distribution of the instrument. The court then asks whether the note involves “common trading for speculation or investment.” SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 353, 64 S. Ct. 120, 124, 88 L. Ed. 88 (1943). In Reves, the court concluded that where a note or agreement merely reflects a single transaction and was not offered to the public, there is no “common trading for speculation or investment,” and therefore is not a security. Reves, 494 U.S. at 66, 110 S. Ct. 945. Furthermore, this factor weighs against the note’s characterization as a security when the instrument at issue is “merely evidence of an obligation to pay.” Intelligent Dig. Sys., L.L.C. v. visual Mgmt. Sys., 683 F. Supp. 2d 278, 285 (E.D.N.Y. 2010). 

(3) Whether there is a reasonable public expectation that the note would be viewed as security. The court then examines whether the investing public would reasonably expect the note to be a security. This factor weighs against the instruments categorization as a security if the “. . . transaction would not be viewed as a security by the public and would not ordinarily be traded as an investment.” Financial Industry Regulatory Authority, Disciplinary Proceeding No. 2014041724601. In New Earthshell Corp. v. Jobookit Holdings Ltd, No. 14-CV-3602 (JMF), 2015 U.S. Dist. LEXIS 27141 (S.D.N.Y. Mar. 4, 2015), the court concluded that where the note merely reflects a single transaction, and was not offered to the public, there can be no “reasonable expectations of the investing public,” that the instrument is a security, because where there is only a single seller, one who expected only to be paid in full for an asset sale, there simply is no “investing public.” Id. at 7. Therefore, where an inquiry into the second factor determines that a note merely involves a single transaction, the third factor is likewise unsatisfied, because where there is no speculation of investment, there is no “investing public.” Reves, 494 U.S. at 66, 110 S. Ct. 945.

(4) Whether some factor, such as the existence of another regulatory scheme significantly reduces the risk of the instrument thereby rendering application of the securities laws unnecessary. In Reves, the court held that the note was in fact a security because in addition to other factors, the notes at issue would have escaped federal regulation entirely if the Securities and Exchange Commission, Rule 144 did not apply. The court in Reves listed several regulatory schemes which may reduce the risk associated with the instrument, including, but not limited to: insurance by the Federal Deposit Insurance Corporation, regulation under the federal banking laws and regulation under the Employee Retirement Income Security Act of 1974. Id.. Where an instrument is afforded some other method of regulation or risk mitigation, it weighs in against the notebeing a security. However, in circumstances where the first three factors weigh so heavily against a finding that the Note is a security, the Court need not consider whether another factor exists reduces the risk of the note.” Intelligent Dig. Sys., L.L.C. v. visual Mgmt. Sys.,683 F. Supp. 2d 278, 285 (E.D.N.Y. 2010)at 285. (emphasis added).

Wow, let that sink in for a moment – could it be that every single conversion of your company’s stock based on a convertible note up to now be subject to a securities law violation analysis? Were legal opinions submitted to transfer agents and brokers that did not properly reflect the nature, origination, purpose and true characteristic of the note under Federal law? You see, if a court determines that the loan was made to correct certain cash flow or cash operating shortages of the company; that the note was not offered to the public for sale; that the transaction was between the issuer and a single other party; that there is no trading market for that actual Note……then Houston, they may have a problem! I have not come across a single convertible note transaction in dealing with dozens of OTC companies that my firm has represented that would meet that criteria to be a security set by the courts.

This would also limit lenders potential claims against an issuer for purported failure to deliver free trading stock after a conversion notice is submitted, and more importantly, would severely reduce a lenders damages claim in court. There is a psychological element when a lender sends a default notice to an issuers CEO wherein the default damages claimed exceed 4 times the amount of the initial loan. Most lenders that sue microcap issuers always inflate their claim for damages relying on contract provisions under certain “make-whole” and “daily penalty” clauses that they lost some sort of market opportunity by the issuer failing to honor a conversion, but the reality is if legally those shares cannot be issued free of restriction, then there is no market opportunity to lose.  This is on top of the recent court decisions in New York that held such “make-whole” provisions are unconscionable and against public policy, voiding out those clauses. It certainly is not good for the lender.  I was before one Federal court Judge in New York on a lenders hearing for a preliminary injunction motion to force a company (my client) to issue stock to it based on a conversion notice, and the judge asked a very enlightening question to lenders counsel – “Why didn’t you just buy the stock from the company at a discount to begin with?” The lenders attorney went silent, ostensibly because he knew that there was no straight-faced way to respond other than expressing some form of greed because his client used an extravagant financial transaction simply to try to avoid criminal usury in New York. In fact, the court followed up quickly and asked; “why did your client make this so complicated?” I knew immediately where the Judge was going as the transaction really seemed to be a cover for usury, and the hearing didn’t fare well for the lender. The lenders request for the preliminary injunction to force the issuer to turn over the stock was DENIED mostly because we successfully raised the issue that the note is not a security, hence, not an investment and since it was a loan, violated New York’s criminal usury statute. That same judge is now contemplating my clients’ motion to dismiss the case based on the defense of criminal usury and must now decide whether to declare the whole transaction void under the New York’s criminal usury statute and dismiss the case.

This means that convertible notes are probably NOT a security as defined by the courts and that a toxic convertible note lender may not be able to convert into free trading shares under the Rule 144 exemption after 6 months.  I know there are attorneys working with certain lenders who have been writing opinions based on Rule 144 exemptions for these types of transactions and in my opinion they are playing with fire. There are certain attorneys as well that “interpret” the decisions in those federal court cases as not applying to convertible notes – those attorneys usually represent some of the lenders as well as issuers, so they are constrained to take that position. COR Clearing published a memo bulletin a few months back wherein it outlined this specific issue, identifying the recent federal court cases and the issue of whether these types of notes are securities and in response, COR severely curtailed, maybe even stopped completely, clearing stock from conversions under these convertible notes. Many transfer agents are now getting smart as well as some issuer securities attorneys and more and more transfer agents are asking for “counter-Rule 144 Opinions” from an issuers securities attorney challenging the facts and supporting documents in a lenders attorneys opinion letter that such stock can be issued free of restriction. The transfer agents however are now finding themselves stuck in the middle because if they issue those securities free from restrictions, they may be subject to DTC, FINRA and SEC actions similar to the SEC federal court case pending against Alpine in New York for SARS and other potential violations. If the transfer agents refuse to issue the shares to the lender, they may be sued. This is why it is important for securities attorneys representing OTC Markets trading company’s to understand the position that COR took and to fully understand the elements that the federal courts look at in determining whether or not a convertible note is in fact a security.

I recently spoke to a friend of mine who runs a transfer agency and we agreed that the convertible Note are now presenting a significant challenge to transfer agents. It seems that some transfer agents would rather take their chances with a lenders lawsuit than be subject to multiple and continuing DTC, FINRA or SEC compliance actions. This is why every single OTC Markets listed company should consider speaking with their securities attorney to determine whether the note(s) meet all of the tests under Reves and Jabookit. If is fails, then lenders can only convert into restricted securities and that may be good news for traders and shareholders as the actual timeline may be pushed out before they can sell under a convertible note, rather than dumping shares to repay themselves in 6 months. 

I suggest that each OTC Company with convertible debt on its books discuss this issue with their securities counsel and transfer agent. It may be time for a new approach.


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