Toxic Funders: Unregistered Dealers, Short Sellers, or Both?

We’ve often written about “toxic” promissory notes or preferred stock and the unregistered dealers who purchase them. These dealers are not the broker-dealers ordinary retail investors have accounts with. They are individuals with companies of their own that they use to provide financing to mostly microcap companies desperate for cash. In the long run, these financings almost always prove deadly for the issuers because of the way they are structured. 

Initially, the company turns to a “toxic funder” or “dilution funder” for money. The company may even be solicited by a boiler room set up by one or more of these people. Like payday loan sharks, they seek out vulnerable CEOs whose companies aren’t gaining the traction they need to survive and offer them deals. 

The deals are not good for the company or for the investors it already has. The funder will sometimes have done research in advance. If not, he’ll ask company management how much money is needed, and then he’ll draw up a stock purchase agreement or securities purchase agreement. He won’t be buying actual stock; instead, he’ll purchase a promissory note, preferred stock, or even a debenture. Whatever the instrument, it will be convertible to the issuer’s common stock. The terms of conversion will be explained in the securities purchase agreement and in the note itself. 

These instruments are always similar, but they aren’t identical. They may vary in ways that accommodate the needs and preferences of the issuer and the funder. A few things, however, don’t change. First, in accordance with the SEC’s Rule 144, once the funder has paid for his convertible note or preferred stock, he’ll need to wait for a while before converting and selling it. The length of the holding period is six months for SEC reporting companies and one year for OTC issuers. For the duration of that period, the stock the note or preferred stock it represents bears a restrictive legend explaining that it cannot be sold into the open market. (It will bear the legend only if the company is still using stock certificates; many no longer do. If the company does not, the transfer agent will maintain current information about the relative restriction in his notes.) 

Once the hold is up, the funder will notify the issuer and its transfer agent that he intends to immediately convert a specific amount of stock. Sometimes, his contract will specify that he does not need to notify the issuer and can proceed directly to the transfer agent. That will save him time. He must also surrender the note itself to the transfer agent. If his intention is to convert only part of the note, the transfer agent will prepare a new note for him or adjust the amount of his remaining investment in his logs. 

For reasons that will be apparent to our readers, toxic funders prefer to work with companies that are SEC registrants because they are obliged to file quarterly and annual reports, along with material event reports on Form 8-K, with the regulator. That makes it easier for the funder to understand what kind of financial pressure the issuer is subject to and, among other things, how much debt it has.

A critical feature of these contracts is that the stock the funder receives will always be discounted. This discount, which is usually between 40 and 50 percent but may be as high as 60 or even 70 percent, is theoretically intended to compensate the lender for the risk he takes while unable to convert and sell during the holding period. The reality is that it’s how he makes his money. The price at which he’ll convert, called the “reference price,” is fixed by averaging the stock’s two or three lowest closing bid prices of the preceding month. (Obviously, if they wished, the parties could agree on just one bid price, or more than three, calculated for a somewhat longer period.) The discount will be applied to the reference price. 

The toxic funder will sell his converted stock into the market. Current investors will rightly see it as dilution, and some will sell. The stock price will decline, perhaps dramatically. Worse yet, our funder will soon sell another tranche. This time, he’ll get even more discounted stock to dump because the reference price will be calculated from lower bid prices than before. This will continue until he’s converted all his convertible securities and sold all the resulting common stock. The company may then need more cash. If so, it’s likely to return to him to cut another deal.

If the company needs money badly enough, it may arrange for sales of toxic convertible securities to more than one dilution funder at the same time. That is likely to result in requests from its older lender or lenders for relief. The amount of that relief, which will be supplied in the form of yet more convertible securities, may already be specified in the original securities purchase agreement negotiated by each of the lenders. 

It’s easy to see how this process could become overwhelming for the issuer’s management. But the toxic funders will not just shrug and walk away. The securities purchase agreement will have a section addressing “default events,” which will come into play should the situation become too dire. For an example, see the promissory note agreed upon by a real company, Bergio International, Inc. (BRGO). BRGO always traded on the OTC, but it was and is an SEC reporting company, though there seems to be some doubt about how long that will continue. It became a public company through a reverse merger with Alba Mineral Exploration, Inc. in October 2009. Though it’s always had a business in what it describes as fine jewelry, from early on, it’s relied heavily on funding in the form of toxic convertibles. As an illustration of a typical convertible promissory note, see the one Bergio sold to Vis Vires Group, Inc. in March 2015 for $38,000. Vis Vires was owned by notorious toxic lender Curt Kramer. 

The instrument’s “Events of Default” takes up the best part of three pages. They include the borrower’s failure to issue shares of common stock to the [note]holder; any money judgment in excess of $50,000 filed against the borrower; “delisting” from the OTC; the borrower’s failure to remain current with its reporting obligations to the SEC; liquidation or bankruptcy; effectuation of a reverse split without 20 days’ notice to Vis Vires, and more. 

Should any of the default events occur, BRGO would be required to pay the holder a “default amount,” whose calculation is complicated and sounds quite scary, within five business days. If BRGO doesn’t comply, “the Holder shall have the right at any time, so long and to the extent that there are sufficient authorized shares, to require the Borrower, upon written notice, to convert the Default Amount into shares of Common Stock of the Borrower pursuant to Section 1.1 hereof.”

If the second were to happen, the toxic funder might end up owning what would be a public shell. Crazy as it sounds, it’s not impossible, and has occurred. But it’s not what either side wants, so it’s more likely that the parties would simply renegotiate the securities purchase agreement, making it even more favorable to Vis Vires. No doubt, the interest on the loan would be raised, and the discount to market on share conversions—originally “60% multiplied by the Market Price (as defined herein) (representing a discount rate of 40%”) –would be raised significantly.

It’s easy to see how profitable these loans are for the toxic funders. At least to observers, the process seems not unlike printing money. In the end, most companies that accept these financings go under. Some stop filing with the SEC because they can’t afford audit fees and eventually have their registration revoked for delinquency. They end up on the Grey/Expert Market, and no one will want to buy the shell because no market maker will file a Form 211 for a company with a past full of toxic debt. 

Bergio is still alive, but its pulse is almost undetectable. Though it’s still on OTC Markets’ Pink Current Information tier, it has no public bid or ask and trades infrequently between $0.0001 and $0.00002. It’s done three reverse splits in the past 10 years: 1:1000 in 2014, 1:10,000 in 2019, and 1:500 in 2023. It has 2.898 billion shares outstanding and 2.898 billion shares in the public float, with 25 billion shares authorized. 

It isn’t hard to see why the instruments BRGO sold to keep afloat are called “death spiral convertibles.” 

Why Does the SEC Allow Toxic Convertible Securities? 

Clearly, toxic convertibles and the people who buy them are usually bad for the companies that issue them, and almost always bad for those companies’ investors. Yes, there’ve been companies that needed short-term loans, sold convertible notes and paid them off by the time they were due with no, or very little, harm done. Unfortunately, that is rare. Most fall further and further behind and end up in a vicious cycle, issuing more and more stock to their lenders until a reverse split is inevitable.

From at least the mid-1990s to around 2017, the toxic funders operated with relative impunity. Occasionally, the SEC would take one to the woodshed, but the money was easy. All that was needed to succeed, really, was seed money. Once a would-be death spiral king made his first few scores, he was on his way to success and a summer house in the Hamptons if he was careful.

One young man, Joshua Sason, did just that and gave a long interview about it to Bloomberg’s Zeke Faux in 2015. Amusingly, he tried to present himself as a mysterious multimillionaire but didn’t fool most of his audience:

Six years ago, Sason was living in his parents’ house on Long Island, doing clerical work for a debt-collection law firm and dreaming of becoming a pop star. Then a family friend showed him a trick that seems to have earned him millions in the stock market. He won’t say exactly what he does or how much he’s made, but regulatory filings by dozens of companies show that Magna has invested more than $200 million since 2012.

Sason, who has full sleeves of tattoos he covers with tailored three-piece suits, calls himself a self-taught value investor. He has about 30 employees in trading, venture capital, music, and film. “I’m not going to give away the details of how we do what we do,” he says in a January interview at his 16th-floor office in Manhattan’s financial district. “We create businesses, and we invest.”

He only technically “invested” in the penny stocks that made him rich. He didn’t make a lot of friends doing what he did. Richard Granville, CEO of a failing OTC issuer called Yippy, Inc., lost his temper when he saw the Bloomberg article, writing things so intemperate that Sason sued him for defamation. Granville responded with a $50 million counterclaim. The case had settled by early 2017, though YIPI’s annual report offers no substantive information.

On his own website, Sason is far from shy:

Joshua Sason is a tenured entrepreneur and investor who, at 22 years old, launched a bootstrapped investment business out of his bedroom and in a few short years, turned Magna into an internationally renowned credit hedge fund HQ’d in New York City.

 At its peak, Magna employed over 70 professionals and invested over $390M of equity capital across ~$1.5B of total transactional value.

He says further that he gave up “the credit business” to go into real estate in 2019, adding that he “credits his spirituality and consciousness for the consistent ability to achieve what many would deem impossible.”

Sason’s move to real estate was perhaps influenced by the lawsuit filed against him by the SEC in February of that year. According to the complaint, in 2012 and 2013, he, a Magna employee, and two broker-dealers “fraudulently obtained unrestricted shares of two microcap stock issuers—Lustros, Inc. (“Lustros”) and NewLead Holdings Ltd. (“NewLead”)—using fake promissory notes issued by those companies. The promissory notes did not reflect bona fide debts of the companies but were fabricated for the sole purpose of justifying the issuance of shares to the Magna Entities. Sason and his deputy, Defendant Manuel, a managing director who negotiated and structured the relevant transactions on behalf of the Magna Entities, knew, or were at least reckless in not knowing, that the promissory notes were fraudulent.”

Sason and his associates then converted the fake notes and sold the resulting stock into the market. Both the Commission and defendants Magna, Sason, and Manuel moved for summary judgment. In May 2023, the Court denied the latter motion in its entirety and partially granted the SEC’s motion. The remaining claims have been left for resolution at trial. The case is complicated and involves yet another penny peculator, Izak Zirk de la Maison, also known as Zirk Englebrecht. Engelbrecht went to prison for other securities-related crimes and was released on February 6, 2024. 

Sason is far from being the only toxic lender to be called to account for his activities. Around 2012-2013, the SEC apparently decided to try to clean up the penny market. First, they went after professional promoters, taking down Awesome Penny Stocks along with the company insiders who worked with APS. Sandy Winick, a shell peddler and more, was arrested in Thailand, extradited to the States, and eventually convicted.

By 2017, the SEC was ready to take on the toxic funders. Their first case was brought against Ibrahim Almagarby and his company, Microcap Equity Group LLC. The allegations made in the complaint were simple:

This case involves the buying of more than $1.1 million of convertible debt of microcap (i.e., penny stock) issuers and the subsequent selling of more than 7.4 billion shares of the microcap issuers’ stock into the market by Ibrahim Almagarby and his wholly owned and controlled business entity, Microcap Equity Group LLC (collectively, “Defendants”), without either registering with the Commission as a dealer or being associated with an entity that was registered with the Commission as a dealer.

Why was Almagarby a dealer? Because according to the complaint, he was doing what he did—not negotiating with issuers to buy “new” promissory notes and then converting and selling them when the holding period expired, but buying “aged” debt that he could convert and sell immediately—“as part of a regular business.” Had he been buying and selling only now and then, as retail investors do, his activities would have qualified him for the “trader’s exemption.” But he was running a business, and that business was the work of a dealer, as dealers are defined in the SEC’s “Guide to Broker-Dealer Registration.” In August 2020, the Court granted the Commission’s motion for summary judgment and denied Almagarby’s cross-motion.

Almagarby’s case was followed by many more, some involving lenders far wealthier than he. However, the Almagarby case is of particular interest at this moment because it was appealed to the Eleventh Circuit. On February 14, 2024, the appellate panel handed down an opinion that most commentators believe is a big win for the SEC. The lower court’s Order had not only been challenged by Almagarby himself. Other interested parties made themselves known. The appellate panel noted that:

After Almagarby filed this appeal, two sets of amici curiae filed briefs in support of Almagarby. First, Trading and Markets Project, Inc., an industry group representing public and private funds, investment advisors, and others, filed a brief and participated in oral arguments as amicus curiae on behalf of Almagarby. Second, the Small Public Company Coalition, Alternative Investment Management Association, and National Association of Private Fund Managers filed an amicus brief.

Both amici were concerned about the same issues. They had no particular interest in Almagarby himself. Like Sason, he was quite young. He’d started his business while still a twenty-something college student. He had no clear idea of the laws governing what he did; he just knew that others were making money, and he wanted to share in the spoils. It never occurred to him that he might have to register with the SEC as a dealer. Trading and Markets Project, one of the amici, was concerned about the chance that the SEC might consider expanding its understanding of who is a dealer to include investment advisers and funds, and urged the Court to consider “that statutory text, history, and context show that to be a “dealer” under the Exchange Act an entity must effectuate orders for customers as ‘part of a regular business,’ … rather than merely trade for investment purposes.”

The appellate panel did not buy that theory:

To be clear, we do not mean to suggest that every professional investor who buys and sell securities in high volumes is a “dealer.” We acknowledge amicus’s concern that an expansive definition might sweep in all manner of market participants not traditionally understood as dealers, including investment advisors, mutual funds, pension funds, and other asset managers. But significant differences exist between Almagarby’s conduct and that of amicus’s investment advisor and fund members. For example, institutional asset managers do not rely on dilution financing or the rapid resale of microcap share issues as their sole source of income. Nor do they employ networks of finders to solicit microcap debtholders or operate without financial disclosures or regulatory oversight. Our holding that Almagarby operated as an unregistered “dealer” in violation of the Exchange Act is based on his specific conduct. And though Almagarby’s underwriting activity is certainly relevant to this determination, it is not the only factor on which we rely.

The Court rejected Almagarby’s contention that he’d been deprived of his constitutional right to due process, and his contention that the disgorgement of more than $885,000 ordered by the lower court judge was not “appropriate or necessary for the benefit of investors.” The Eleventh Circuit agreed with the SEC on all points but one: it reversed the penny stock bar applied to Almagarby because he had not committed deliberate fraud.

The amici curiae active in this case have moved on to other similar ones. We have not heard the last of their arguments.

Do Toxic Funders Also Short Sellers? 

As anyone who follows SEC registrants trading OTC and Nasdaq Capital Market issuers knows, in the past three years, there’s been a renewed interest in short selling on the part of investors who are, for the most part, poorly informed and susceptible to conspiracy theories. Most have been influenced by the “meme stock” movement. They believe enormous short squeezes are fairly normal and appear to be unaware that the SEC considers trying to make them happen to be securities manipulation.  

Some of these people, and some others who’re more knowledgeable, wonder if toxic lenders sometimes short—even short naked—in the course of their business. The latter, at any rate, is not possible. They already own the securities they’d need to cover their short positions. It should also be noted that while the Commission now takes the stance that toxic lenders must register as dealers because they’re buying and selling as a regular business and with an eye to distribution, that will not necessarily make them broker-dealers, much less market makers. We bring this up because market makers can short-sell naked for the purpose of providing liquidity for investors. 

The SEC issued its final rule for what would become known as Regulation SHO, or just Reg SHO, at the end of July 2004. At that time, concerns about evil short sellers filling the financial ether with “air shares” that severely depressed the price of the investments of ordinary people were running high. There was some reason for those concerns. The exchanges didn’t like the idea of naked short selling for anyone but market makers, and no one associated with OTC trading was really paying attention. It is, in fact, true that some non-MMs shorted naked. They did so not because they wanted to cheat but because it could take time to locate shares to borrow. They’d call their broker and place the order. It would be filled. A few days later, the brokerage would get the locate. Sometimes, the client had already closed his position by then. 

It would obviously be a different story if our trader were a hedge fund manager with deep pockets. That thought alarmed the Commission, and so Reg SHO was designed to make naked short-selling against SEC regulations. It was phased in over a couple of years, and there were some rocky moments, but two decades later, it has proved to be extremely successful. 

In the final rule, the Commission says very little about convertible securities. It does note that the cost of finding locates for OTC stocks “could affect the ability of these small issuers to obtain financing through the issuance of convertible debentures, in that market participants that buy these convertible debentures may not be able to sell short for hedging purposes if they are unable to locate the issuer’s securities. This could affect the ability of these small issuers to obtain financing through the issuance of convertible debentures, in that market participants that buy these convertible debentures may not be able to sell short for hedging purposes if they are unable to locate the issuer’s securities.”

Interestingly, it adds its concerns about individuals using “the recent controversy over naked short selling to engage in fraud, or otherwise distract investors from fundamental problems with the company.” There was, in fact, a good deal of that going on in the late 1990s and early 2000s. 

At that time, there was a lot of general interest in convertible securities. Some academics wrote papers. Two are still of some interest today. The first, published in 2001 by Pierre Hillion and Theo Vermaelen, is called “Death Spiral Convertibles”; the second, published in 2004 by Zachary T. Knepper, is called “Future-Priced Convertible Securities & the Outlook for “Death Spiral” Securities-Fraud Litigation.” Both seem somewhat quaint today. They see the existence of these kinds of toxic convertible securities as a relatively new development; both believe they first appeared as financing instruments in the mid-1990s. 

Knepper, who to some extent builds upon the work of Hillion and Vermaelen, makes an unusual prognostication early on:

Vermaelen report provides empirical evidence for this: 85% of the firms studied saw declines in their stock prices within the first year of issuing an FPS, and these declines averaged 34%. Yet companies may feel that they have no choice but to issue an FPS if the alternative is closing the firm. ((This perhaps explains why some companies have issued multiple FPS’s, even after suffering stock losses as a result of prior deals.) But the heyday of the Future Priced Security appears to be over. As one market participant has noted, this is “a business that doesn’t exist any more, because everybody got tired of losing money. … Public companies themselves have eliminated this from the market. They just won’t do these types of deals any more, with anybody.”

Then, as now, some issuers were suing the firms that specialized in toxic convertibles. And that is where short selling enters the picture:

Issuers allege that purchasers have used this to their advantage by, for instance, engaging in massive short selling of the issuers[sic] stock to intentionally depress the stock’s price. Then, after a few weeks or months when the issuer’s stock has fallen (sometimes to nothing), the purchasers convert their FPSs into huge numbers of shares, covering their short positions. Indeed, because of the way FPSs operate, purchasers have an incentive to short sell: the lower the stock’s price, the more shares the FPS purchaser can achieve at conversion and, since the return is fixed, the more shares that can be used to cover short-selling positions.

Accusations of that kind were what led to the sprawling and successful Operation Bermuda Short, an investigation that aimed its guns at U.S., Canadian, and even some European financial miscreants, many of them known or believed to be short sellers. Many of the biggest fish escaped unscathed. Around the same time, work on Reg SHO began. It proved far more effective at addressing the problem of abusive short selling than did Bermuda Short.

Hillion and Vermaelen did some exploring and found that interest in death spiral convertibles had made its way to the internet, which in 2001 was still shiny and new. 

This negative price momentum may be accelerated by selling pressure from professional short sellers who seek out such companies as short selling opportunities. This type of activity has even reached the Internet, where we came across various “death spiral clubs” who systematically search SEC filings for death spirals and advise others to short the issuer’s common stock.

The authors provide a footnote that names the financial chat board Silicon Investor as the home of those “clubs.” The reference is clearly to Anthony Elgindy’s “club,” which was, in fact, called just that and had its own website as well. Elgindy himself was a professional short. His club members shorted along with him, but they were not professionals. When he was arrested for engaging in stock manipulation with an FBI agent, most of them scattered and were never heard from again.

Back then, certainly, some toxic funders did “sell ahead” of receiving their common stock from the issuer’s transfer agent. They would short the stock and make money on the short sales. If the stock price declined, all the better. They would then convert and sell their note or preferred shares, and since the price was now lower, they’d get even more commons to dump into the market. Vermaelen and Hillion do successfully demonstrate that by doing so, they could increase their profit. 

But there’s no real suggestion that the toxic funders are doing that now. Naturally, they may want to convert their first tranche of a conversion when the price looks right to them. But we think they fully understand that if they sell ahead and short-sell the amount of common stock they’ll receive in the conversion, they’re running no risk. They already own the security.

They can spend the money they make on attorneys who’ll help them register as dealers.


To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Park Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. 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 Attorneys
Brenda Hamilton, Securities Attorney
200 E Palmetto Park Rd, Suite 103
Boca Raton, Florida 33432
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