The New Type of Convertible Note Transaction on the OTC Markets – a Dirty Trick?

Updated: Nov 16, 2021

OTC Markets CEO’s and advisors need to be aware of the “new” convertible note type transaction that has started to take the place of the typical convertible note transaction. We start with the premise that the difference between a loan and an investment is that a loan requires absolute repayment and an investment supposes an actual risk that the money invested can be lost. This is the defining difference between a loan and an investment. It simply boils down to whether or not the money advanced is subject to risk of loss. No matter how its presented, this is the nationwide test adopted by all federal and state court. This is important because 1) if the transaction is truly a loan, then it is subject to state criminal usury laws, and 2) if the transaction is an investment, it is subject to the federal Securities Act where registration as a dealer requirement plays a big role.

Enter the new transaction promulgated by some convertible note lenders ostensibly in response to feeling the heat from the SEC enforcement actions for lenders failing to register as “dealers” under the Securities Act, as well as various state courts getting very close in determining whether those transactions are criminally usurious and void under state criminal usury laws. One tell-tale sign is that the lenders themselves are changing the names of the entities through which they do business. They believe that a new entity does not have the history of engaging in the business of buying and selling securities for their own accounts, a typical dealer activity under the ACT. They may also use a “straw” person, or a nominee, to front the company, but I recommend looking deeper. They may “assign” existing convertible notes to that entity, or an entity under their actual control but fronted by a straw person, in order to get around possible “Bad Actor” labels by the SEC and/or FINRA, in order to get corporate actions approved by FINRA. (FINRA will most likely not approve a corporate actions, such as a reverse stock split, if your company has several convertible notes, especially if one of those note holders are run by a “Bad Actor” as defined under Section 506(d) to Regulation D).

As creative the current forms of fixed discount rate convertible notes are, and that these “lenders” enjoying several years of uninterrupted guaranteed returns at the expense of issuers and their shareholders, the recent SEC actions have them scrambling to both rehabilitate their existing notes as well as attempt another misdirection away from their business model.

Entering the funding arena is the newest attempt to shield their greed, the “Callable” Preferred Securities transaction.

Here is how the term sheet and/or stock purchase agreement works:

The lenders provide funding by purchasing a certain new class of convertible preferred equity, convertible into common stock again at steep fixed rate discounts to the market price of the securities with a typical 10 to 20 day look-back in order to get the lowest stock price to apply their conversion discounts. These instruments also have voluntary redemption “rates” by the company should you choose to “redeem” the preferred stock early, usually before the 180 day waiting period under Rule 144 expires, and the redemption price is fixed based on additional percentages depending on the timing of the redemption before the expiration of the 180 days. There is usually a mandatory redemption period as well, providing for a finite term of the transaction. If these provisions invoke an eerie feeling of déjà vu, well, your gut is probably right.

Here is a side by side comparison of some of the terms of notes and Callable Preferred stock Purchase Agreements:

Convertible Notes Callable Preferred Stock Purchase

Term: Between 9 and 12 mos. Mandatory Redemption b/t 12 and 18 mos.

Pre-payment: Prepayment Penalties Early Redemption Penalties

Conversion to Common Stock at Discount Rate:

Between 30% and 60 % discount Between 29% and 59% Discount

20-day look back 20-day look back

Default: Typical Typical to Convertible Notes

Limits on Conversions: 4.99% 4.99%

I believe that these new funding instruments do nothing to help their business models because each form of transaction still guarantees a return of their money, just like a loan, and, these are again, most likely transactions in securities subject to federal Securities laws including the dealer registration requirement. Maybe they are hoping it will take several years for state and federal courts, and the SEC, to catch up with this new instrument before they find the similarities in form, conduct and application so they can continue to enjoy their enormous guaranteed returns stemming from the issuers stock.

There is a more detailed analysis coming over the next couple of weeks, but we thought it important to warn OTC Markets companies of this new funding instrument.

Here’s a novel thought for these lenders, register as a dealer under the ACT, subject yourselves to SEC and FINRA Oversight and play by the rules. Change your conversion discount rates from a fixed rate percentage discount to the stocks trading price, to a fixed price discount locked in at the time the transaction is made and keep that discount price (and other rates charged under the loans) under the states usury laws where the issuer is headquartered.

For more information about what is discussed in this article, please feel free to contact me at or call us at 516.455.1500.

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