What are Convertible Securities?

Convertible securities include bonds and preferred stock.  For OTC Markets and Bulletin Board companies, the term usually means a debt secured by a Promissory Note, which can be converted into common stock.  These are known as Convertible Notes or simply Convertible Debt.

Convertible Debt in OTC Markets Companies

Most convertible promissory notes issued by OTC Markets public companies include provisions that allow the debt holder to decide if and when to convert a Note into common stock.  SEC Rule 144 usually allows a debt holder to trace their holding period to the date of the Note, rather than the date of conversion, which could be months or years after the Note was issued.

Why Do OTC Markets Companies Issue Convertible Debt?

OTC Markets companies issue Promissory Notes primarily to raise capital or to pay for services. It is a fact of life for services providers that OTC public companies often lack the cash to pay their vendors.

Why Do Debt Holders Convert Promissory Notes into Stock?

Statistically, experienced OTC lenders and service providers accepting Convertible Notes in lieu of cash know that microcap companies quoted on the over-the-counter markets will probably default on their obligation to pay.  Given that probability, drafters of Convertible Promissory Notes must take into consideration that the debt holder will later need to convert a defaulted Promissory Note into common stock after the Rule 144 holding period has been satisfied.

9.99% Blocker Clauses in Convertible Promissory Notes

Convertible Promissory Notes issued by OTC Markets  companies usually include “blockers” which are clauses preventing the debt holder from owning greater than 9.99% of the OTC company’s issued and outstanding shares of stock at any one time.  This blocker is intended to prevent the debt holder from being classified as an Affiliate, which would cause Rule 144 Affiliate volume trading limitations to be applicable under Rule 144.

Exceeding 9.99% ownership in an SEC reporting company also brings the obligation of filing SEC Forms 3, 4 and 5.

Institutional financiers that specialize in providing capital to OTC Markets Pink Sheets and Bulletin Board companies using convertible debt typically do not convert a Note again until they are “flat.”  Being “flat” means that the common stock in their brokerage account from the prior conversion has all been sold, such that it is easy to verify with the Company and Transfer Agent that the debt holder has complied with the 9.99% blocker.

4.99% Blocker Provisions in OTC Markets Convertible Debt

For SEC reporting companies filing under the Securities Exchange Act of 1934, sometimes the blocker clause will specify a maximum of 4.99% if the debt holder also wants to avoid the additional obligation of filing a Schedule 13d or Schedule 13g.

When a debt holder converts a Note into 5% of the common stock in company subject to the reporting requirements under Section 12 of the Securities Exchange Act of 1934, the debt holder is required to file a Schedule 13D or 13G.

The rationale behind the 4.99% blocker is that the institutional financiers who provide capital to multiple OTC Markets and Bulletin Board companies tend to do many conversions.  Typically these lenders will only convert after the stock can be cleared using a Rule 144 legal opinion or Section 4(a)(1) opinion, and they will convert the debt in regular increments which are then immediately sold into the market, such that their accounts are flat before each subsequent conversion.

Such repeated and regular conversions in which stock is owned for perhaps only a few days at a time would cause an administrative burden to file multiple SEC forms each time the debt holder’s ownership in a particular OTC Issuer fluctuated above and below 5%.

Conversion Metrics and Formulas in OTC Convertible Debt

Convertible Promissory Notes issued by OTC Markets and Bulletin Board companies to raise capital or pay for services usually contain a conversion ratio based on fluctuating market prices.

Converting OTC Stock at a Discount to Market

That ratio or formula of a market price conversion is typically referred to as a “discount to market” which means that the debt holder will have the right to convert at a share price that is a particular percentage of the share price on the date of conversion or based on some average during a trailing conversion period.

Rule 144 and Section 4(a)(1) Legal Opinions for Debt Conversions

Management and Debt Holders of OTC Markets and OTC Bulletin Board companies can contact OTC Securities Lawyer Matt Stout for Rule 144 legal opinions and Section 4(a)(1) legal opinions at (410) 429-7076 or mstout@otclawyers.com.