Legal Question in Business Law in California

Bankruptcy protection from convertible promissory noteholders

I have several individual investors who hold convertible promissory notes. This investment vehicle was chose to give the investors protection against future institutional equity investment that never came (dotcom bust). The business continues to grow, but the unpaid, unconverted notes (valued at about $350k among 8 people) are overdue.

Now they are a dangerous liability, as the noteholders can sue for payment, and I cannot yet pay. This would effectively force me to go into bankruptcy for protention, and allow one or two of them to benefit from the tax loss against their other gains, while screwing over the others. I don't think I can convert the notes to equity, as was the original intent, without institutional investment.

Question: Can I somehow convert the convertible notes to equity? Or do I voluntarily go into bankruptcy to shed the debt and reorganize? If you are an attorney who is familiar with this type of issue, please include contact information with your response. Thanks.

Asked on 10/14/02, 11:09 pm

2 Answers from Attorneys

Bryan Whipple Bryan R. R. Whipple, Attorney at Law

Re: Bankruptcy protection from convertible promissory noteholders

It's not clear from the question whether you as an individual are the issuer/debtor, or whether your use of "I" simply personifies a corporation or other entity that you control. This could have an impact on the answer and the advice.

As you probably know, the unpaid interest may represent an obligation that gives each holder standing to participate in an involuntary bankruptcy petition. In some cases, a single creditor may file a petition. Also, as you may know, these notes would almost certainly be regarded as 'securities' and the federal and state securities laws will apply to the issuer and the notes.

Although it may be that two of the investors could come out of a bankruptcy better than others, that would depend on circumstances peculiar to them, and as a general rule an investor is always better off when paid in full than when getting 50c or 0c on the dollar in bankruptcy.

The notes represent contracts with the investors, and what you can and cannot do will be governed largely by the terms of the contract(s), and perhaps to a lesser extent by securities law. In order to answer your question, an attorney would have to review all the circumstances of their issuance, including informal promises and assurances made to the investors as well as any formal investment memoranda, subscription forms, and the like. Generally, an issuer cannot force the holder of a security to accept a different security unless provided for in the terms of the issuance.

If the issuer is a corporation, it might be possible to accomplish some of your objectives through a merger, or through a transfer of assets to a different entity. The laws of the state of incorporation would have to be reviewed.

Whether to execute some kind of asset-rescue maneuver, convert the notes, negotiate a workout or go through a preplanned reorganization in bankruptcy cannot be addressed without a thorough review of your organization, its future potential, your/its other debts, creditor attitudes and a host of other issues.

I am a former entrepreneur of 35 years' experience, now practicing business law as a second career. I have limited bankruptcy law experience but more in the areas of small business, securities, investments, finance, and that sort of thing, including an extensive law library on these topics.

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Answered on 10/15/02, 1:25 pm
Nathan Drage Nathan W. Drage, P.C.

Re: Bankruptcy protection from convertible promissory noteholders

An attorney speciallizing in bankrutcy will certainly be able to help you minimize the financial impact of the outstanding promissory notes.

As to whether you can convert them (force conversion) depends on the terms of the notes themselves, which would have to be reviewed. Also, I was unclear about your statement "I don't think I can convert the notes to equity, as was the original intent, without institutional investment." What did you mean by that?

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Answered on 11/07/02, 2:35 pm

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