Securities Law, NYSE, NASDAQ & OTC Markets Listings & Compliance

Convertible Financing

For decades, microcap issuers on the OTC Markets in need of financing have largely been forced to turn to what are known as “toxic funders” or “toxic lenders.” The money they offer comes with a hefty price tag. It’s paid in exchange for convertible securities that are almost invariably market-adjustable. That means the toxic funder will purchase from the issuer a specific number of instruments—promissory notes, warrants, or preferred stock—that will, after the shares have been registered with the SEC or the holding period required by Rule 144 has expired, be converted into common stock and sold into the market. Theoretically, holding the shares creates risk for the funder because the price of the issuer’s common shares could decline dramatically while the funder waits to sell. 

But in reality, the lender runs almost no risk because the conversion price of the lender’s securities isn’t at a fixed price from the outset. Instead, it’s market adjustable, which means it will be determined based on the stock’s price (often its bid price) a few days before the conversion is to take place. Usually, the toxic lender will convert and sell in tranches on an ongoing basis. That is done for two principal reasons: (1) to increase the toxic lender’s profit and (2) to make it possible for the lender to avoid being considered an affiliate or control person.

The toxic lender accomplishes the latter through an “equity blocker” clause in its contract with the issuer. They limit the amount of common stock—but not convertible securities—the toxic lender may own at any one time to no more than 9.99 percent (or sometimes 4.99 percent) of the issuer’s shares outstanding shares. So, the toxic lender is free to convert and sell successive tranches on an ongoing basis within a short period of time, if he wishes. 

The toxic funder’s sales will be dilutive and will likely drive down the stock price. If that happens, thanks to the market adjustable feature of the convertibles, the toxic funder will receive stock at a lower price and even more stock the next time the toxic funder converts, and even more thereafter.

If more than one toxic funder is involved, the dilution may become catastrophic within a fairly short time. Those additional toxic funders may have anti-dilution clauses in their own contracts, which will worsen the situation for the issuer. Eventually, the company may be forced to consider a stock reverse split. Read More