Recently, the Securities and Exchange Commission filed a complaint against Curt Kramer and three companies owned by Kramer, 1800 Diagonal Lending Company, LLC, Power Up Lending Group, Ltd., and Geneva Roth Remark Holdings, Inc. (Securities and Exchange Commission v. Power Up Lending Ltd., et al., No. 1:24-cv-03498). The SEC alleges that Kramer, by making convertible loans to microcap companies through 1800 Diagonal, Power Up and Geneva Roth, acted as a securities dealer without having the required securities licenses. To understand the case, and its ramifications, we first need to understand how these loans work.
What are Microcap Companies?
Microcap issuers are typically smaller companies that have shares of common stock that can be traded on an exchange, or more commonly, the OTC Market. Most of these companies have a limited public float, low trading volume, and a trading price below $5.00, and sometimes below a penny. As a result, microcap companies may struggle to raise equity capital through a traditional underwriter, and may not have the assets or dependable revenue stream to obtain bank financing. A company in this situation may turn to a merchant cash advance or a lender offering convertible debt. This isn’t to say microcap companies aren’t viable businesses. Some are early stage and may have gone public before they were ready. Others are mature companies that were disproportionally impacted by COVID or other industry-specific conditions (perversely, some companies thrived during the height of the pandemic, but found that their revenue dried up after the restrictions eased). These are the companies that turned to Kramer for funds.
What is Convertible Debt?
Simply put, convertible debt is a loan that under certain circumstances can be converted by the lender into shares of stock before the loan is paid. There are some common elements to most of these loans. First, it is expensive money. Often there is an original issuance discount, or OID. Basically front-loaded interest, if the OID is 10% and the company borrows $100,000, then the borrower will only receive $90,000 but will have to repay the full $100,000. On top of the OID, there will be a hefty interest rate, above what a bank would charge, and possibly other fees for document preparation and due diligence. But the issue that the SEC focused on is the conversion feature.
The conversion rate that determines how many shares of stock that the lender is entitled to upon conversion is typically not fixed and floats with the market price of the underlying stock. Although the conversion rate may be defined innocuously as the “market price,” in reality it will be a steep discount to market. First, the conversion price will be based on the lowest stock trade during a lookback period before the conversion, usually from ten to thirty days. This lowest trading price is then discounted further, by ten to fifty percent. Often the resulting conversion price is sub-penny, and the conversion of even a small loan can cause significant dilution. In addition, the lender has a limit on how much it can convert at any given time to avoid SEC reporting requirements that kick in for 5% and 10% shareholders. So instead, the lender converts only a portion of the debt equal to just below 5% and then dumps those shares into the market, which drives the price down (remember, that given the discounts, the lender can sell well below market and still make money). And once those shares are sold, the lender can convert more of the loan based on the artificially depressed market price created by the lender’s selling. For this reason, this type of conversion is sometimes referred to as a “death spiral” caused by the underlying “toxic debt.” If that isn’t enough, some of 1800 Diagonal’s notes provide that if the borrower defaults, the borrower must repay double the amount of the loan and interest outstanding.
Generally, these loans are papered with a securities purchase agreement and convertible note. There may also be security, guaranty, and registration rights agreements. Often these loans also include a warrant sweetener, which may have a market exercise price or may be a “prefunded” warrant with a de minimis exercise price.
Why Did the SEC Pursue Kramer?
Kramer and his companies aren’t the only ones offering convertible debt to small publicly traded companies. In the complaint, the SEC referred to Kramer as a “two-time recidivist violator of the federal securities laws,” but there appear to be some other reasons why the SEC is pursuing Kramer. In our experience, most of these convertible loans are only convertible if the borrower defaults, meaning that if the borrower repays the loan on time, then the lender does not have the right to convert the loan. For these loans, the conversion right is similar to a type of security that protects the lender — if the borrower is unable to pay, the lender converts and sells shares until the loan is considered repaid. However, most of Kramer’s loans were convertible after six months, regardless of whether the loan was in default, and some were converted in full before they were due (the six-month waiting period complies with SEC Rule 144, which allows a borrower to treat the shares as having been paid for when the loan was made, and freely sell them into the market after six months have elapsed without registration). In these cases, Kramer wasn’t protecting himself when a borrower couldn’t repay a loan. Instead, it appears he made the loans with the intent to convert at a discount and profit by selling the shares in the market. And profit he did. According to the complaint, from January 2018 to March 2023, Kramer’s companies made at least $60 million selling converted shares in the market after investing in approximately 325 issuers in nearly 2,000 transactions and converting loans into more than 90 billion newly-issued shares of common stock.
The SEC concluded that this amounted to engaging in the regular business of buying and selling securities without registering as securities dealers and requested the disgorgement of ill-gotten gains and an order prohibiting Kramer from converting any of the loans outstanding. Kramer has not yet filed an answer but has said he is innocent and will defend the case aggressively.
What Should You Do If You Have Convertible Debt?
Despite the risks enumerated above, convertible debt can be an effective financing option and may be one of the only viable choices available for certain companies. But before you sign on the dotted line, we recommend that you have experienced counsel review the loan documents to make sure that you fully understand the terms, especially because key provisions are often hidden in the middle of a lengthy convertible note. Our team is familiar with these agreements and can quickly point out where the mines are buried. And for companies that have outstanding loans with 1800 Diagonal, Power Up or Geneva Roth, there may be unforeseen ramifications flowing from the SEC’s suit. For example, if a borrower plans to proceed with a corporate action that requires FINRA review (a merger, dividend issuance, stock split, or name or domicile change), FINRA may object to the action under FINRA Rule 6490(d)(3) because a person connected to the borrower is subject to a pending SEC action alleging securities laws violations. Our securities team is available to consult on appropriate next steps for companies faced with these issues.
