Toxic Financing Deals: The Love of Short-Sellers

You may have come across an OTC stock over your years of trading and investing that had one of the worst combination for any OTC investor and the company for that matter.  At some point the company decided to take on debt to finance operations, which included the rights of the debtor to call the debt due and have shares issued to cover the debt.  This convertible debt is commonly referred to as toxic financing.


From an investors perspective it is relatively obvious how damaging this type of toxic financing can be to your investment.  Once the debt is converted into shares of common stock, the sale in the public markets inevitably dilutes the percentage ownership of your shares in that company.  The additional shares in the market, if not acquired by interested buyers, can depress the stock price.  This form of dilution is music to the ears of short sellers who can have a tremendous impact on the stock price during the dilution.

Here is a basic scenario of what happens during periods of dilution, and the ultimate reason for a stock pps decline:

• Dilutive MM shows up on the ask (e.g. BMAK or VFIN/VERT)
• MM's such as VFIN & VERT work in tandem to maximize the pps realized for the group or individual selling the stock.
• One shows on the bid to symbolize strength, while the other will show 10k on the ask so that those buying will buy at the ask instead of parking on the bid
• It might take a day or two for the market to realize that dilution is in fact taking place
• The chatter on stock message boards quickly changes
• New aliases show up touting the ill effects of this dilution, calling the company a scam, POS, and more
• This causes emotional investors to react irrationally selling into the bid
• Short-selling commences and often-times involves them jumping over the dilutive MM to sell shares to the interested buyers
• Then the walls on the ask show up to push the price lower to be able to cover
• If the dilutive MM is not finishing selling their shares, this cycle continues and the short-sellers can continue to depress the stock price

Ultimately, short-selling in illiquid markets has the potential to ruin a company.  Once the stock price is depressed, interested buyers may be wary of the company and sit on the sidelines.  The company may need to raise capital by selling additional shares of equity, but either have to sell at extremely low levels, which means the amount of shares they have to sell is multiplied or they simply cannot find buyers at all.


The solution to this problem needs to be addressed by the markets them self.  Institutional investors, banks, and large retail investors do not like the risk involved with these types of companies.  Thus, these companies have limited resources when it comes to raising financing.  A desperate CEO will likely end up taking a toxic deal in the hopes that they can pay the debt prior to it maturing.  When they can't, the market value of that company takes a huge hit.

Making additional financing options available to these small and micro-cap companies will help to address some of these market-related issues.  Companies will take on less toxic financing and hopefully have better opportunities to grow their business.