What are Convertible Securities? l Securities Lawyer 101
A “convertible security” is often structured as a bond, note, preferred stock, or a wraparound agreement that results in the conversion of the debt obligation into common stock. The holder of the convertible security or the company may have the ability to determine when the holder of a convertible security must convert. In recent years, the penny stock markets have been plagued with dilution funders using various types of debt securities to issue unrestricted shares.
OTC Markets’ quoted issuers often raise capital by selling convertible securities to dilution funders. Larger companies that have access to capital from public offerings registered with the SEC and traditional bank financings might conduct an offering of convertible securities for business reasons, but for microcap issuers, convertible securities are often the only means of funding available. They may have fixed conversion prices, or fluctuating prices that change based on the market price of the issuer’s securities.
They may include an anti-dilution clause, so that respective proportional ownership remains the same regardless of the issuance of additional securities, reverse stock splits or other corporate restructurings.
Where a conversion ratio is based on fluctuating market prices, the holders of the convertible security are protected from price decreases, but both the company and its stockholders are subject to devastating market risks including dilution. Because a market price based conversion can cause an issuer’s stock price to decline dramatically, with corresponding negative effects on both the company and its stockholders, convertible securities with market price conversion terms are commonly known as “toxic” or “death spiral” fundings. Death spiral financing is commonplace on the OTC Markets OTC Pinks and is often a feature of pump and dumps and other fraudulent schemes cooked up by dilution funders and shady investor relations firms.
Frequently, the issuance of “free trading” securities upon conversion of preferred stock or convertible securities, particularly by OTC Pink companies, violates the registration provisions of federal and state securities laws, often because the issuers are former shell companies and Rule 144 is not available. Additionally, these companies frequently omit material disclosures required by the OTC Markets related to the issuance of convertible securities. In recent years, the Securities and Exchange Commission (“SEC”) has pursued numerous actions against issuers and dilution funders in connection with toxic convertibles. Additionally, the agency has brought enforcement actions against a trail of sleazy attorneys who render legal opinions for convertible debt transactions.
OTC Pink and SEC reporting companies alike should be aware that any arrangements or agreements to issue “free trading” shares upon conversion of debt or convertible securities requires public disclosure. In fact, on January 3, 2013, OTCMarkets significantly increased disclosure requirements for its Pink Sheet Current Information tier with the absolute requirement that issuers report a laundry list of corporate events within four days of their occurrence. These events include the entry into or termination of a material definitive agreement (this includes agreements involving convertible securities). There are few things more material to investors in public companies than the potential for dilution of their investment. “Federal securities laws, such as Rules 10b-5 and 15c2-11 of the Securities Exchange Act of 1934 (“Exchange Act”) as well as Rule 144 of the Securities Act of 1933 (“Securities Act”), and state Blue Sky laws, require issuers to provide adequate current information to the public markets… Persons with knowledge of such events would be considered to be in possession of material nonpublic information and may not buy or sell the issuer’s securities until or unless such information is made public.”
Risks of Convertible Securities Based Upon Fluctuating Market Prices
♦ An issuer sells convertible securities that allow the holder to convert into common stock at a discount to market, which means the lower the issuer’s stock price falls, the more shares are issued upon conversion.
♦The more shares the company issues, the greater the dilution to the issuer’s shareholders will suffer. The issuer will have more shares outstanding, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula.
♦ The more shares issued upon conversion, the higher the probability that the issuer’s stock price will decrease. The more the stock price decreases, the more shares the issuer will have to issue for future conversions.
These dangers are very real. In 2012 Radiet Pharmaceuticals, once a NASDAQ company, fell behind on its financing obligations. After desperate measures to catch up failed, it was forced to agree to convert all its outstanding debt to common stock. In the space of a few months, its shares outstanding ballooned from 29 million to 1.3 billion. Stock price fell into the hundredths of a cent, with the company’s former financiers selling all the way down.
Issuers should understand the terms and risks of convertible securities so that they can make informed decisions about the funding they accept. They must also ensure compliance with applicable securities disclosure and registration requirements. Issuers should also bear in mind that significant share issuances and below market conversions will make it difficult for the issuer to obtain other types of financing. Death spirals can destroy companies.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
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Boca Raton, Florida 33432
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