‘Death-Spiral Financing’ Leads to SEC Fraud Charges Against Penny-Stock Operator

So much of the focus on fraud these days involves exploiting holes in software, hacking into systems to steal personal information and payment data, or otherwise using digital methods in heists. But recent news involving “death-spiral financing” reminds us that fraud is still conducted in other, relatively old-fashioned ways.

In a tale that roughly recalls the 2013 Martin Scorsese film “The Wolf of Wall Street,” the U.S. Securities and Exchange Commission has sued financier Joshua Sason for fraud. Sason, who is 31, hit it big “by making loans to desperate penny-stock companies and was using the money to try to turn himself into an entertainment mogul,” according to Bloomberg. He even “made a cameo in the boxing movie ‘Bleed For This,’ which he produced with Martin Scorsese.”

SEC Allegations

Sason ran a company called Magna Group, and according to the SEC, raked in more than $25 million via what the federal agency in its complaint described as an operation that involved the quick dumping of penny-stock shares that had been illegally gained. The complaint also targets three other people involved in the alleged fraud, which the SEC said took place in 2012 and 2013.

Magna and Sason “engaged in a scheme to acquire fake convertible promissory notes supposedly issued by penny stock issuer Lustros Inc. and then to convert those notes into shares of Lustros common stock, the federal agency said in a statement. “The defendants then sold the shares to unsuspecting retail investors, who did not know that the shares were fraudulently acquired and were being sold illegally. The defendants’ sales of the Lustros shares also had the effect of destroying the value of the Lustros shares held by the public.”

Another instance of the alleged fraud involved a “fake promissory note from Pallas Holdings” along with fake debt that was to be retired “in exchange for shares of the issuer through a court-approved settlement agreement,” the SEC said.

Through a comment given to Bloomberg, an attorney for Sason and Magna denied any wrongdoing and said the SEC allegations are “without any factual or legal basis.”

The mechanics involved in these alleged instances of fraud are known as death-spiral financing. “Critics call loans like his ‘death-spiral financing’ because they drive stocks into the ground,” according to the Bloomberg report. “Sason said in an interview … that his deals were intended to help companies.”

Death-Spiral Process

So how does death-spiral financing work?

“In death spiral finance a lender typically agrees to loan a publicly-traded company some amount of cash. In exchange the lender takes a convertible debenture with typically a reasonable interest rate,” reads one description of the process. The money, however, “doesn’t come without a catch: the lender can convert his/her debenture at any time into shares of common stock. In typical fashion, such an offer will come without a predetermined number of shares but instead with a share conversion rate that is a moving target which is always less than the prevailing market rate. That way, when the investor … sells the shares [that person] will always profit, even on the downside.”

In 2013, an SEC official said this about death-spiral financing, an observation that seems relevnt in the wake of the SEC allegations against Sason and Magna: “Certain convertible securities, particularly those referred to as ‘toxic’ or ‘death spiral’ convertibles, present the temptation for persons holding the convertible securities to engage in manipulative short selling of the issuer’s stock in order to receive more shares at the time of conversion.”

The fraud allegations leveled against Sason and Magna came as another legal case — the recently concluded trial of the Mexican drug lord known as El Chapo — showed how prepaid debit cards are apparently being used more often by such criminals to help launder massive amounts of cash, much of it in small denominations.

Fraud comes in many forms (which requires a nimble approach to fraud prevention.) But as the cases against Sason and El Chapo have shown in recent days, fraud and money laundering are not just about data breaches, hacks and account takeovers.