A bad financing is a business problem. A badly described financing is a securities problem. The distinction matters because the SEC does not generally second-guess an issuer's capital decisions — it examines whether investors were told enough to understand them.
The Disclosure That Draws Comment
Staff comments cluster around a familiar pattern: a convertible note described in general terms, a conversion price described as "a discount to market," and no quantification of what that means for the share count.
Language that reliably attracts scrutiny includes:
- › "The Company entered into a convertible note for working capital purposes."
- › "The note is convertible at a discount to the market price."
- › "The Company may issue additional shares upon conversion."
Each statement is true. Together they leave a reader unable to estimate dilution, which is the entire point of the disclosure.
What Adequate Disclosure Contains
A description of a variable-rate convertible note should let a reader reconstruct the math. In practice that means:
- › The formula. The exact discount, the lookback period, and whether the reference is closing price, low trade, or VWAP.
- › Floors and caps. Whether a conversion floor exists, and if not, say so plainly.
- › Shares issuable at the current price. A stated share count as of a recent date, with the price used.
- › A sensitivity table. Shares issuable if the stock falls 25, 50, and 75 percent — this single table resolves most staff comments before they are written.
- › Default consequences. Principal step-ups, retroactive interest, and any share penalties.
- › Reserve obligations. Shares reserved with the transfer agent and whether an authorized-share increase will be required.
- › Historical experience. Shares actually issued on conversion during the period and the prices at which they converted.
Placement Across the Filing
- › Risk factors. A specific dilution risk factor, not a generic "we may need additional capital" paragraph. Name the instrument.
- › MD&A liquidity. Explain that the note is a source of capital whose cost is share-based and indeterminate.
- › Financial statement footnotes. Derivative liability accounting for the embedded conversion feature, with the valuation inputs.
- › Capitalization and dilution sections of a registration statement, including the effect on existing holders.
- › Item 3.02 or Item 1.01 current reports where the terms are material.
The Officer Certification Problem
Principal executive and financial officers certify the accuracy of periodic reports. An officer who signs a report that materially understates dilution exposure cannot rely on not having understood the conversion mechanics. In an enforcement posture, that lack of understanding tends to be used as evidence of recklessness rather than as a defense.
The practical safeguard is a written internal memorandum, prepared before execution, that models the instrument and is circulated to the officers who will certify.
Restatement and Correction
If the accounting treatment of an embedded conversion feature was wrong, or prior filings omitted the mechanics, the correction path is a considered one: assess materiality, determine whether prior filings can no longer be relied upon, and disclose the correction in a way that describes what changed and why. Quiet revisions in a later filing, with no acknowledgment, create a second problem on top of the first.
Related Reading
- › Form S-1: Where the SEC Applies Scrutiny
- › Toxic Financing: Death Spirals & Dilution
- › Toxic Convertible Notes: How Death-Spiral Financing Works
- › The SEC Comment Letter Response Checklist
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Authoritative Sources
- 15 U.S.C. § 78o(a)(1) — Registration of brokers and dealers (Exchange Act § 15(a)(1)) — Cornell Legal Information Institute
- 15 U.S.C. § 78c(a)(5) — Definition of “dealer” (Exchange Act § 3(a)(5)) — Cornell Legal Information Institute
- SEC v. Keener, 102 F.4th 1328 (11th Cir. 2024) — convertible note funder as unregistered dealer — U.S. Court of Appeals for the Eleventh Circuit
- SEC Investor Guide: Microcap Stock — dilutive financing and market risks — U.S. Securities and Exchange Commission
- 17 C.F.R. § 229.303 — Item 303, Management’s Discussion and Analysis (liquidity and dilution disclosure) — Electronic Code of Federal Regulations
- 15 U.S.C. § 77c(a)(10) — Exempted securities (Securities Act § 3(a)(10)) — Cornell Legal Information Institute
Primary sources are cited so readers can verify the law directly. Rules and staff guidance change; see our editorial and corrections policy to report an error or an outdated citation.
Frederick M. Lehrer served as an enforcement attorney in the SEC's Division of Enforcement at the Southeast Regional Office from 1991 through 2000, and concurrently as a Special Assistant United States Attorney in the Southern District of Florida from 1997 through 1999, prosecuting securities-related financial crimes. He has practiced securities and corporate law in private practice for more than twenty-five years, advising issuers worldwide on SEC registration, disclosure obligations, Regulation D private placements, Regulation A offerings, and going public transactions. The firm is based in Florida and serves clients internationally.