Toxic Convertible Financing and OTC Markets Issuers

Toxic convertible financing, also known as ‘death spiral financing,’ is a common pitfall for small and emerging companies trading on the OTC Markets. These financings typically involve convertible promissory notes that convert into stock at deep discounts to market price. Although these transactions may appear to offer quick funding, they often lead to severe shareholder dilution and SEC enforcement scrutiny.

What Is Toxic Convertible Financing?

Toxic convertible debt usually involves a note that converts into common stock at a floating conversion rate, often at a discount to the lowest trading price during a look-back period. With no floor on the conversion price, the number of shares issued increases as the stock price falls, creating a cycle of dilution and price decline.

Dilution Risk and Market Impact

The dilution from toxic financing can devastate OTC issuers with limited liquidity. Repeated conversions flood the market with discounted shares, depressing prices and destroying shareholder value, which may lead to OTC Markets downgrades. Issuers must promptly disclose note terms and conversion details under the Alternative Reporting Standard or through Material Event Reports.

SEC Enforcement and Convertible Note Lenders

Until recently, the SEC had increased enforcement against toxic note lenders and issuers, targeting unregistered dealer activity, illegal distributions, and misleading disclosures. Lenders converting notes for resale have been deemed unregistered dealers under Exchange Act Section 15(a), while issuers may face actions under Rule 10b-5 or Section 17(a) for failing to disclose dilutive terms.

OTC Markets’ Position on Toxic Convertible Financing

OTC Markets requires issuers to disclose all convertible note terms, noteholders, conversion formulas, and dilution impacts. Failure to do so can result in downgrades or quotation suspensions. OTC Markets compliance staff monitor filings for signs of abusive conversions or repeat reverse splits.

Preventive Strategies for Issuers

• Avoid deeply discounted or floating-rate conversions.
• Disclose all note terms and conversions promptly through OTCIQ.
• Model dilution scenarios before issuing new debt.
• Engage experienced securities counsel for compliance with Rule 144 and Rule 15c2-11.
• Maintain current information status to preserve trading eligibility.

Key SEC and OTC Markets References

• SEC Rule 144 – https://www.sec.gov/rules/final/2020/33-10842.pdf
• SEC Litigation Releases – https://www.sec.gov/litigation/litreleases.htm
• OTC Markets Issuer Reporting Guidelines – https://www.otcmarkets.com/learn/otc-markets-reporting-guidelines
• FINRA – https://www.finra.org
• OTC Markets – https://www.otcmarkets.com

Conclusion

Toxic convertible financing remains a top enforcement priority for regulators and a major risk for OTC issuers. These financings can quickly lead to catastrophic dilution, enforcement actions, and loss of investor confidence. Issuers should avoid abusive note structures, disclose all financing terms, and maintain transparency to protect both compliance and market integrity. Hamilton & Associates Law Group assists issuers and investors with convertible debt compliance, Rule 144 opinions, and OTC Markets disclosure obligations.

If you have any questions about this article or would like to speak to a Securities Attorney, Hamilton & Associates Law Group, P.A. is ready to help. Our Founder, Brenda Hamilton, is a nationally known and recognized securities attorney with over two decades of experience assisting issuers worldwide with going public on the Nasdaq, NYSE, and OTC Markets. Since 1998, Ms. Hamilton has been a leading voice in corporate and securities law, representing both domestic and international clients across diverse industries and jurisdictions. Whether you are taking your company public, raising capital, navigating regulatory challenges, or entering new markets, Brenda Hamilton and her team deliver the experience, strategic insight, and results-driven representation you need to succeed.

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

Hamilton & Associates | Securities Attorneys
Brenda Hamilton, Securities Attorney
200 E Palmetto Rd, Suite 103
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855
www.SecuritiesLawyer101.com