Death-Spiral Compliance

Have you heard of a Death-Spiral Convertible? This isn’t some car gone-bad. It also isn’t a new roller-coaster ride. It is a type of debt. It is a convertible because it can be converted into equity. It is called a Death-Spiral because it is an option only taken by public companies who are strapped for cash with no better options. Taking this option is could be a quick way to the death of the corporation, so, it should be only taken with no other options available.

Jason Sason of Magna investments
Jason Sason of Magna investments

Death-Spiral Convertibles recently came up in the news because of a young investor named Joshua Sason, who owns Magna Investments, recently made headlines by becoming a multi-millionaire using this lending method.

Here’s how it works:

A publicly traded company with low equity valuation in dire need of operating cash with no where to find it goes to an investment fund. They strike up a deal. The fund gives the company money in exchange for an IOU. One of the conditions of that IOU is that if the company cannot pay back the loan, the company will give equity instead. The value of the payment with equity is lower than the market value. Not just lower but a lot lower. Often, it is 25% or 25% of the market value. So, if the company’s shares are trading at $1 per share and the company was supposed to make $1,000 payment but did not have the cash to do so, it could pay 5,000 shares instead. Those share, of course, are valued at $5,000. Normally, a fund wouldn’t want to own shares of a company that can’t even pay its loans, but in this case, the shares are discounted so much that it can immediately sell the shares at a profit. If the conditions are right, the company cannot ever pay the monthly payments and the fund keeps getting those shares. The fund then sells those shares at a price that will guarantee them being sold, often at 50% of their market value. So, even though the fund was holding onto $5,000 worth of equity, since the fund doesn’t believe in the company’s ability to pay back its debt, it tries to unload the shares as soon as possible. Even at $2,500, the fund would have been paid, essentially, $2,500. That payment, of course, is made by the market, not the company, but the neither of them care. The company needs to keep cash and the fund wants to be paid back. Continue doing this every month for 6 months, and the fund would have diluted the equity in the market, it would have been paid handsomely, well above what it would have received it if the company could service its debts, and the share price plummets toward $0. This is a loan designed to kill the equity value. A fund that is interested in doing this would have to find a company that doesn’t have a chance of surviving.

This brings up an interesting compliance issue. Section 3 of the Securities Act of 1933 that deals with exceptions to normal equity underwriting requirements. Specifically, section 3(a)(10) deals with paying with equity for claims against the borrower. It allows these transactions with some conditions. So that not every equity offering doesn’t goes through this exception, the SEC allows the lender to sell the securities as a payment after holding onto it for at least three months. If the lender sells the equity into the public market in short order, the lender will be considered an underwriter, who may not be licensed to be an underwriter, let alone considered to be issuing unregistered stock.

For practical purposes, if you are a lender who wants to take advantage of this, selling the shares on the first day of the fourth month is a bad idea. Lenders who are interested in doing this have taken to doing it around six months. So, lenders are taking a risk for six months and hope that the company survives at least that long. SEC sees this as holding the securities long enough to be taking on a credit risk.

About the Author: Marcus Maltempo is a compliance professional with more than a decade of experience helping banks, law firms and clients manage investigations and regulatory responses.