Tips For MicroCap CEOs Handling ‘Toxic’ Debt [Guest Post]

Guest Post By: Mark R. Basile, Esq.
toxic-

By the time small cap OTC/PINK SHEET Company CEO’s realize they can’t raise any more money, many try fighting an uphill battle, or simply close the doors. The ones most hurt by this are the shareholders. Toxic Convertible Debt, unless it’s managed correctly, could be the death knell of a company and it doesn’t matter how great your technology, products or ideas are either.  This is a form of legal loan-sharking (except in states such as New York, California, Massachusetts, Texas and Florida).

Toxic loans are usually for small amounts of money, between $25,000 and $100,000 that after 6 months, start to convert into the company’s common stock at a steep discount (I have seen between 35% and 65% to start with) and in some states, the amount of the discount puts such transaction into the criminal usury stratosphere. I have seen OTC company’s trade at $7.00, then fall to .005 in a matter of 6 months, due directly to the unabashed selling of stock a lender receives at a discount – and they don’t give a rat’s ass about the CEO, the company or its shareholders. They are not “investors”. They are lenders and have figured out a very clever, and sometimes, legal way to extract an enormous return on monies loaned to the company, no matter what they call the transaction.

Here are a few key points for CEO’s to think about:

 

1 – Don’t take the money.  If it’s too easy to get, it’s usually too good to be true.  I have seen many CEO’s take this easy and quick money, and at the 6-month anniversary, the company stock starts the death spiral downward into sub-penny.

2 – The company’s stock’s value will be decimated over the next 12 months, no matter how cleverthe CEO or its counsel think they are in getting the lender to make modifications, or what “IR” firms tell you of their capabilities. Leak-outs, lock-ups, etc….are usually temporary and usually ineffective solutions. IR firms sometimes are able to help bump the stock price up to offset the toxic lender selling, but “ IR campaigns” are usually short lived (a week or two at most), and in the end, to clear a $35K note could end up costing the company $40K in “IR” fees plus restricted stock with no basis, so when that comes due–watch out.

3 – By the time the CEO realizes it, they don’t have enough “reserve shares” for the lender to keep converting, causing them to amend their corporate documents to increase the number of authorized shares, and next thing they know, they have a billion or more shares issued and outstanding, with a stock price in the sub-pennies, something they will never recover from unless they take action.

4 – Add insult to injury. The above examples are when the company has only 1 note, most OTC/PINK SHEET companies have at least 3, and more average closer to 5. This is where the cluster-f@!k happens. Several note-holders all converting at once, trying to race each other to get the most out of their loan before the other one does. Now they are in deep trouble.

5- The company will eventually be sued when their stock price collapses to the point where the lenders cannot get their money back from the stock, so they will sue the company, and sometimes even the CEO and Board of Directors. They will not walk away.  Toxic lenders will use a lawsuit as a hammer to extract more money from the company, even though they may have made 5 times their money back already via stock sales, and lets face it, they have the money, the attorneys and the resources to put the screws to the company.

 

OK, what can CEO’s do? They could go to battle with them, especially in states like New York, California, Massachusetts, Texas and Florida, if the Note and Stock Purchase Agreement is controlled by any of those states laws. If CEO’s don’t defend the lawsuit, the lender will get a default judgment against the company and start to attach its assets like bank accounts until they squeeze every last dime back.

Also, each suit will cost a company between $10K and $20K just to retain counsel and I have to tell you, some lawyers are good, and some, not so good, especially in this specialized area of the law. The best defense the company has is the defense of Criminal Usury under NY Penal Law 190.40.  In NY, any charges the lender charges or reserves that exceed 25% of the amount you received under the Note (loan) is criminally usurious and is void, under NY law.  That’s right –VOID-.  Meaning, they can’t collect and can’t force a conversion. However, there are only a handful of attorneys that really understand the nuances of this law, but it’s a good start, especially if your lenders are well known for making toxic loans to small public companies.  Most of these toxic lenders use New York as the stated jurisdiction and choice of law. If the attorney that the CEO chooses is good, and they have enough money, then they have a decent shot in New York.  The problem is defending several lawsuits at once, and frankly, it’s easier to settle and use the money the company is going to spend on lawyers, and put that money towards a private restructuring.

Private restructurings are usually designed and tailored differently for each company, based on their trade and vendor debt, as well as their toxic note debt. A private restructuring does a few things for the CEO.  It allows them to tailor a new capitalization structure to their unique financial situation  This is done several ways and includes creating new classes of equity, one of which is dedicated to remediate the debt with some beneficial terms to the toxic note holders (move the debt off the books into longer term equity), effectuate a stock split to reduce the number of shares issued and outstanding, and recapitalize management and the board. This will position the company to attract new longer-term capital, acquisition funding and provide a new footprint to build off of.  I firmly believe that any public company can be saved, but you really need a coming to Jesus meeting with the realities of the situation, and more importantly, the realities on how to fix it. Litigation should be a last resort, but it can be an effective tool while the CEO is taking steps to restructure.

 


About Mark R. Basile, Esq. 

Mark R. Basile is a nationally known New York corporate restructuring and workout attorney and is a member of The Basile Law Firm. The Firm represents numerous OTC and Pink Sheet companies in both litigation and corporate restructurings.

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Mark R. Basile

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