Predatory lending in all of its myriad of forms has been around since the concept of lending first arose. Call it payday loans. Call it “going to the corner” to borrow from a person with the middle name “the” in the securities world, that toxic lenders comes in the form of convertible notes.
A quick note on the convertible note: A convertible note is a debt security that contains an option in which the note will be converted into an amount of the issuer’s shares. The conversion can be at a fix number or at a variable rate. Just like any other debt investment, convertible notes offer investors the ability to earn interest. Rather than cash payments, however, the interest payments typically will accrue and the amount the company owes the investor will increase over time. This type of company financing has the advantage of being fairly simple to execute. This means the process of issuing the notes is relatively inexpensive for companies and it allows them quicker access to investor funding. A downside to this quick access to investor funding is that companies may end up carrying excessive debt, which could push them into insolvency or bankruptcy.
Convertible notes are not, by themselves, bad. Convertible notes allow a lender to enjoy some of the potential upside on an investment. However, convertible notes based on a variable conversion ratio or a conversion ratio discounted from the stock price during conversion are toxic lenders. They are “death spiral” notes.
To understand why these notes can create a death spiral, two, separate concepts must be explored in the micro- and small-cap markets.
First, micro- and small-cap markets have limited trading. A micro- or small-cap stock does not have the liquidity and the trading volume of a “big board” company. Since the market does exist to absorb large blocks of stock, the bid (the price for which people will buy a stock) and the ask (the price for which people will sell the stock) are different, and the difference can be wide. What the holders of the toxic lenders debt do is “hit the bid” or sell the stock at the price at which a buyer will purchase the stock. At a fixed rate of conversion, the seller of the converted stock has no incentive to flood the market, lowing the bid prices. At a variable rate of conversion, the seller need only “hit the bid” hard enough to lower the price of the stock to liquidated their entire holding – each time a portion of the note is converted, it is converted at a lower price, generating more stock to flood the market.
Once caught in the death spiral, a company’s price is cooked.
On October 14, 2021, the New York Court of Appeals said: “Not so fast.”
The New York Court of Appeals, on a decision certified to it by the Second Circuit Court of Appeals, determined that “death spiral” convertible notes may be usurious, and void under New York law.
New York usury law comprises General Obligations Law §§ 5-501, 5-511, 5-521; Banking Law § 14-a (1); and Penal Law § 190.40. Together, the statutes establish that loans of less than Two Hundred Fifty Thousand Dollars ($250,000) to individuals cannot exceed a Sixteen Percent (16%) annual rate, loans between Two Hundred Fifty Thousand Dollars ($250,000) and Two Million Five Hundred Thousand Dollars ($2,500,000) cannot exceed Twenty-Five Percent (25%) per annum. Twenty-Five Percent (25%) per annum is the criminal usury rate. Loans in excess of Two Million Five Hundred Thousand Dollars ($2,500,000) are not subject to the usury laws. The General Obligations Law and Banking Law provide that the maximum rate of interest upon a “loan or forbearance of any money, goods, or things” shall be Sixteen Percent (16%) per annum unless otherwise provided by law. General Obligations Law § 5-501 ; see Banking Law § 14-a ). “No person or corporation shall, directly or indirectly, charge take or receive any money, goods, or things in action as interest” at a rate exceeding Sixteen Percent (16%). General Obligations Law § 5-501 .
In the state of New York, a lender commits a class E felony when, without other legal authorization, the lender “knowingly charges, takes or receives any money or other property as interest on the loan or forbearance of any money or other property, at a rate exceeding Twenty-Five Percent (25%) per annum or the equivalent rate for a longer or shorter period” Penal Law § 190.40. Any loan that reserves or takes any greater interest “than is prescribed in section 5-501”—the civil usury prohibition Sixteen Percent (16%) per annum “shall be void” unless the lender is a bank or loan association, which will be held to have forfeited all interest on the loan. General Obligations Law § 5-511 . Under General Obligations Law § 5-521 (1), the defense of usury is not available to corporations, but this bar does not preclude a corporate borrower from raising the defense of “criminal usury” (i.e., interest over Twenty-Five Percent (25%)) in a civil action. (see id. § 5-521 ). See also, Adar Bays, LLC v GeneSYS ID, Inc., ___NY3d___, 2021 NY Slip Op 05616, *3 .
When a loan is criminally usurious, the loan is void ab initio and invalid. You must be aware of toxic lenders.
If you are involved in a “death spiral” convertible note, seek legal counsel.