OTC Markets Death Spiral Funders Days may be Numbered

Updated: Nov 11, 2021

For the last several years, toxic convertible note funders have had their way with small, under-funded OTC Markets publicly trading companies and we have been warning the markets about the absolute devastation these transactions impose on an issuers stock, both killing market cap and shareholder value. Our firm has been fighting with these lenders in various courts around the country on behalf of OTC Markets issuers on a variety of grounds.

There is now a three-pronged attack against this industry that may signal that the time of the convertible toxic note may be numbered.

The crux of a convertible toxic note is the ability of the lender to repay itself, without any interference by the issuer, with the issuers stock. The “conversion” feature simply means that principle and interest charged on the note is repaid with company stock at a fixed discount to the stocks trading market price, not a fixed price per share. This is important because after 180 days, securities law (known as Rule 144), allows the lender to start converting its debt into stock. For some of you that have experienced the pain when lenders start converting, if your document’s call for a fixed 35% discount to market on conversions, that means the issuer is repaying the loan at a 54% gain to the lender, on every conversion. So, no matter where the issuers price is trading, that discount is applied to every conversion. The contracted for 4.99% “blocker”, meaning the lender and issuer cannot issue or convert debt into shares on any conversion wherein the lender would own more than 4.99% of the stock because then, the lender would have to report its purchase of the stock to the SEC. The purpose of the “blocker” is so they don’t have to notify or account to the SEC or other oversight body, such as FINRA.

Currently, there are 3 key events that every public company CEO, shareholder and Board member of any OTC Markets issuers should be following;

Usury Law Lawsuit in New York

The application of states usury laws to the convertible note. After having several frustrating decisions go against some of our clients at the lower federal court level, the Second Circuit Court of Appeals in New York agreed with our position that such transactions may be subject to criminal usury laws (New York) and certified questions of law to New York’s highest court, to specifically determine the issue of whether the fixed discount percentage that guarantees that 54% return, is actually interest. The New York Court of Appeals will decide what its’ state criminal usury statute means and how its applied to the convertible note discount. If the court agrees with us, the transaction is void under New York law. This will be a landmark decision that can be applied in all states that have criminal usury statutes. This itself may cause thousands of convertible notes to be void because under New York law, the transaction is void ab initio (as it never happened) and the lender loses its money and be subject to other actions including going back and suing to vacate judgments and to recover payments and/or overpayments (or value of stock) transferred in the past.

Dealer Registration Lawsuits

Recently, the SEC has commenced enforcement actions against some of the more well-known known toxic convertible note lenders including John Fife and his companies Chicago Venture Partners, LP, Iliad Research and Trading, LP, St. George Investments LLC, Tonaquint, Inc. and Typonex Investment, LLC (SEC Litigation Release), John Fierro and his company JDF Capital, Inc. (SEC Litigation Release ), Justin Keener and his company JMJ Financial (SEC Litigation Release ), and Ed Liceaga and his company River North Equity LLC, (SEC Litigation Release). The SEC also commenced an enforcement action against Ibraham Amalgarby and his company Microcap Equity Group, LLC (SEC Litigation Release). These enforcement actions mostly center around the failure to register as a “dealer” under the Securities and Exchange Act of 1934. Under 15 U.S.C §78o, anyone who engages in the business of buying and selling securities for their own account, must register as a Dealer under the Act. The penalty for not doing so is that the rights created by the transaction, as to the violator, are void (15 U.S.C. §78cc of Section 29b). This means that the violator may not be able to commence action(s) to collect on the transaction. It also means that as to the innocent party, usually issuers, the transaction is “voidable” at the victim’s option. The Supreme Court has recognized a private right of action for rescission in these cases. The law in this area is still developing, but if recent court decisions are an indicator, there may be a world of hurt coming to toxic convertible note lenders. In the above-mentioned actions, each lender moved to dismiss their cases on the grounds that the SEC did not plead its case and that they didn’t have to register as dealers under the ACT, only to be slapped down by federal courts. Liceaga (Decision ), Keener (Decision) and Fierro (Decision) all lost their motions to dismiss the cases against them. Fife, who is represented by a large and fairly prestigious law firm, Gibson Dunn, has filed its motion to dismiss in his case, and we will see where that goes in a month or two. However, in the Almagarby matter, a federal court actually granted to the SEC summary judgment finding that buying and selling convertible notes without registration violates the act and granted summary judgment to the SEC (Decision). The Almagarby decision sets a low bar as to the conduct and mechanics of these lenders that buy convertible notes, then resell the resulting stock they receive from conversions into the market. (All parties in those suits are presumed innocent).

SEC Proposed changes to Rule 144 as Specifically Applied to Convertible Notes

More recently, The SEC has proposed rule changes to the “tacking” provisions of Rule 144 and has made the administrative decision that such tacking should not apply to convertible notes. (See SEC Bulletin Announcing Rule Change). If this rule change is adopted, it basically ends the variable rate convertible note industry and hundreds of thousands of shareholders in OTC Markets companies should be very happy. What the proposed rule does is effectively prevent the convertible note holder from utilizing tack back provisions of Rule 144 to the date of the initial loan when it seeks to repay itself with stock. This rule has its genesis in two areas. The argument we have been making is that these loans are not true investments until the lender makes the decision to use its principal and interest to acquire the stock. Typically, the convertible note lender waits until day 181 after the loan is made to submit a compulsory conversion notice (that includes the discounts discussed above) to the issuers transfer agent, that issues free trading shares because the stock they receive is exempt under Rule 144 and the tack back provision allows the transfer agent to issue unrestricted securities. This is where the death spiral was born because the lender could put in serial conversion notices and immediately sell the stock after each conversion, thereby never exceeding the 4.99% blocker. This usually results in walking down the stock price, hurting the company's market cap and shareholder value. The tack back provision is key to effectuating the death spiral. The second feature is that even when the note-holder converts and receives stock, rarely, if ever, do those note-holders hold the stock and take any risk. They usually immediately sell the stock, reaping the gains from the discount as discussed earlier in this article and such practices being highlighted by the federal courts in some of the recent federal court decisions denying dismissal of the SEC case(s). There is no such thing as a “riskless investment”, but that’s what these note-holders have created for themselves.

The proposed rule changes align with the position that these are not securities in the sense that they aren’t pre-buying common stock through the future conversion feature (but the Securities Act does make a convertible note a security by definition – 15 U.S. Code §77b), but rather, issuing loans and only when the note-holder converts its note to stock, does the tacking of rule 144 begin. This does away with almost all the games, possible market manipulation and short selling since after each conversion, the note-holder (now shareholder) must wait another 6 months before it can sell and bear the risks of any other typical investor. They still get the stock at a discount, but they will be forced to play by the rules that apply to everyone else and hold the stock as an actual investment that will be subject to that stocks market fluctuations.

I also recommend quickly reviewing research provided by Utopia Capital Research, a community of short-sellers and veteran traders that provide analysis on a myriad of issues including toxic convertible notes. The Utopia research report provides a very small sampling on the harm caused to issuers and their stockholders. You can review their report here.

If you are the CEO of a public company and have taken convertible floor-less toxic debt, issued warrants, or entered into an equity line of credit and you want to know more about your rights in connection with these new developments, feel free to reach out to me at mark@thebasilelawfirm.com

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