Toxic Funding Lawsuit – Usury Interest
Danger – Toxic Financing
In a previous blog article we looked at Toxic Financing, how it worked, and the impact it can have on a company. Just over 18 months ago, there was a Federal Appellate court decision on a toxic funding lawsuit that changed the world of finance for micro-cap companies. The US Court of Appeals for the Second Circuit ruled that the stock discount applied at the time of conversion should count towards calculating the rate of interest. Essentially, toxic financing created usury interest. This court decision has effectively brought an end to the toxic funding industry as we know it.
What is a Toxic Funding
A Toxic Funding involves the issuance of a preferred stock or convertible debt that has no downside price limitation at which the holder of the preferred shares or debt can convert into a potentially unlimited number of common shares, which are then sold into the market place. These convertible preferred and convertible debts usually convert into common shares based upon a formula (“floating conversion rate“) that is effectively a discount to the market price of the shares at the time of the conversion. A blog article “Toxic Financing Explained” went into greater detail what a toxic financing is, and how to identify the language creating one.
The Lawsuit
On approximately May 24, 2016, GeneSys ID, Inc. a company whose shares traded on the Over-the-Counter market under the ticker symbol “GNID” entered into a loan agreement with Aday Bays, LLC. a lender based out of Florida. The loan agreement stated that all disputes would be subject to the laws and jurisdiction of the State of New York, and that any actions brought by either party against the other must be brought in the state of New York. Just over six (6) months later, when Adar Bays would be able to have the restrictive legend removed on any shares it received as a result of a debt conversion, it submitted a conversion request which GeneSys ID refused to honor.
Adar Bays did not take kindly to this refusal to honor its conversion request, and filed a lawsuit in the United States District Court Eastern District of New York. [1:17-cv-01175-ALC]. GeneSys eventually answered the complaint claiming that the note provided for a level of interest that was a criminally usurious rate of interest under NY Penal Law, and thus was void as a matter of law. A copy of Adar Bay’s complaint can be found (here), and GeneSys’ answer can be found (here).
The district court initially ruled against GeneSys, which then appealed the decision to the federal Court of Appeals. The Court of Appeals vacated the district court’s ruling, and determined that the conversion discount should be counted towards the interest rate. Shortly afterwards, Adar Bays and GeneSys reached an out of court settlement.
A link to a pretty good article discussing this lawsuit in greater detail can be found (here)
We are not surprised at the Court of Appeals ruling. For a very long time companies have been forced to take charges based upon Black Scholes or other models in determining the cost of warrants and other stock options they issue. In many instances when these warrants were issued in connection with debt issuance, their charges were counted as interest. To me, it seems as if the court system has finally caught up with long standing accounting rules.
How is this Changing Things
This so called “toxic funding lawsuit” had a massive ripple effect throughout the toxic finance industry. Many of the toxic lenders immediately updated their documents to change the venue for disputes out of New York. Others immediately changed their business focus. For others, it took a longer time for things to sink in. Most of the toxic funders were are aware of have shut down or are in the process of winding down their operations. Don’t get me wrong, there are still a few firms out their providing toxic funding; however they are all a lot quieter than they used to be.
Where do things go from here ?
It looks to us as if there toxic financing industry is winding down. There are still a lot of corporations who are unaware of the Court of Appeals ruling. As more corporations discover the ruling, it is going to be a lot harder for toxic funders to find companies to take there money. There are also a lot fewer broker/dealers willing to accept stock issued as a result of a toxic financing. There will always be a few companies willing to take the money from these firms, but it is going to be a lot tougher to make things happen.
As far as the litigation over toxic financing goes; I spoke with the attorney who won this lawsuit last year at Planet MicroCap in Las Vegas. He said he was continuing to litigate on behalf of companies and shareholders he believes were defrauded by toxic finance firms. He also talked about a lawsuit where he was applying civil RICO statutes against a toxic finance firm. At the time, he said he was wining the lawsuit. He does win it, things are really going to get bad for the people behind these toxic financings. It will be interesting to see what he has to say at this year’s conference.
About Coral Capital Advisors
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