Dilution Funders and Dilution Financings Challenged by SEC

We recently wrote about two interesting SEC enforcement actions that examine the question of whether the individuals and entities that purchase convertible promissory notes from public companies are “dealers” according to the definition established in Section 15(a)(1) of the Securities and Exchange Act of 1934 (“Exchange Act”). Informally known as “toxic lenders” or “dilution funders” because the terms of their financing agreements contain provisions that almost always result in harm to investors and issuers alike, they’re considered by many to be the scourge of the penny stock market. Typically, the notes they buy can be converted at any time, often at a discount to market price of 70 percent or more. As the lender converts and sells, stock price drops. To avoid making insider filings to the SEC, the lender’s financing agreements specify that he may own no more than 4.99 percent of the company’s stock at any time. But that in no way stops him from converting his note continuously, in a succession of tranches. Since the conversion ratio is pegged to the security’s recent average bid price, every time he converts, he gets more stock than the time before. As he sells tranche after tranche, the company’s stock price enters freefall. Sometimes the only remedy for the issuer is a large reverse split.
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