Attorney Mark Basile to Participate in Federal Enforcement Action SEC v. Carebourn Capital L.P. and Chip Alvin Rice
Over the past seven years or so, we’ve followed the Securities and Exchange Commission’s efforts to rein in the excesses of predatory lenders who purchase convertible notes, preferred stock, debt, and sometimes warrants from issuers desperate for the cash needed to keep their businesses afloat. On July 23, 2024, a federal judge in Minnesota gave permission for Mark R. Basile, an attorney representing DarkPulse, Inc., to intervene in a SEC enforcement action against Carebourn Capital, L.P. To allow a third party to play a role in litigation brought by the SEC is unusual, perhaps unprecedented.
For startups and other very small companies, traditional financing can be hard to come by. Banks are uninterested, and while Regulation D offerings can always be floated by public companies, there’s no guarantee that interested investors will be found.
The so-called “toxic funders,” or “toxic lenders” however, are almost always available, willing to supply a needy startup with small amounts of cash on a regular basis. Some even deal in amounts in the millions. It can seem like a dream come true for an issuer sure that success is just around the corner. The toxic lender proposes a deal and prepares a stock purchase and other agreements that will be signed by the public company’s management.
If our startup’s management is new to all this, he may feel relieved. The converitible note will probably not mature for some time. The stated annual interest rate on the loan is not outrageous. If the company finds itself unable to pay the lender back in cash, the public company’s management needn’t worry. All that’s required is for them to issue stock to the lender when he asks to convert part of his note into the company’s common stock. Even that won’t happen for six months if the issuer is an SEC registrant, or one year if it isn’t. Those first six months will be a honeymoon period for the uninitiated. There will be no conversions because of the Rule 144 holding period. During that time, the note or preferred stock will bear a restrictive legend explaining that it cannot be sold into the open market. That will, of course, happen only if the company is still using stock certificates; many no longer do. If the company has eliminated certs, the transfer agent will maintain current information about the relative restriction in his notes.
Once the holding period has expired, the note conversions will begin. The toxic lender will send notice to the company and its transfer agent, informing them how much of his note or preferred stock he wishes to convert. Sometimes, he need only inform the transfer agent who will have irrevocable transfer agent instructions signed by the public company on file. Usually, he’ll convert only part of his note, because he does not wish to become a greater-than-five percent holder, which would oblige him to file Schedules 13 describing his position to the SEC. The transfer agent will convert the amount of stock requested, and amend its transfer logs to reflect the conversion.
If company management is inexperienced, that is the moment at which it realizes it’s dealing with people who could be described as close relatives of payday loan sharks. The most important feature of the stock purchase agreement is the ratio at which the note will be converted to common stock. There will always be a considerable discount to the market price for the lender. This discount, which is usually between 40 and 50 percent, but may be as high as 60 or even 70 percent, is theoretically intended to compensate the lender for the risk he takes while unable to convert and sell during the holding period. The reality is that it’s how he makes his money. The price at which he’ll convert, called the “reference price,” is fixed by averaging the stock’s two or three lowest closing bid prices of the preceding month. (Obviously, the parties could agree on just one bid price, or more than three, calculated for a somewhat longer period, if they wished.) The discount will be applied to the reference price. The toxic funder will sell his converted stock into the market. Current investors will rightly see it as dilution, and some will sell. The stock price will decline, perhaps dramatically. Worse yet, the toxic funder will soon sell another tranche. This time, he’ll get even more discounted stock to dump, because the reference price will be calculated from lower bid prices than before. This will continue until he’s converted all his convertible securities and sold all the resulting common stock. The public company may, by then, need more cash. If so, it’s likely to return to him to cut another deal.
Most toxic lenders prefer to work with SEC registrants. Because the Securities Exchange Act of 1934 requires them to make periodic financial filings, the lender can easily keep track not only of the business’s financial condition, but it can also keep abreast of how much other debt the issuer has. It is also easier to for the lender to deposit the shares it receives upon conversion. Usually, falling behind with SEC filings is considered to be a default event. If it occurs, the loan will probably be renegotiated, to the lender’s advantage. Very likely the lender will receive an even deeper discount to market for his next conversions. That is not the only default event possible. If they pile up, or if the issuer digs in its heels and refuses to honor conversion notices, the lender may sue. In a few cases, a victory awarded to the lender has resulted in his becoming the new owner of the company and all its assets.
Some issuers that sign on for toxic debt end up taking funding from as many as five or six different funders. Eventually, the dilution they sustain will send their shares outstanding into the billions. A whopping reverse split will be the only way out, and chances are that in a year or two the process will be repeated. By then, most investors will have left. The company will become known as a chronic diluter, and eventually, the business will shut its doors and the empty public shell will be reassigned to the Expert Market, whence it probably will never return.
SEC Enforcement Actions Against Dilution Funders
The SEC has long been aware of the problems created by toxic lenders. Investors were slower to catch on, for a long time blaming “their” companies’ ballooning share counts on largely nonexistent “naked” shorts rather than on the real culprits. By the middle of the last decade, the regulator had conceived a new idea, based on a new interpretation of what a securities dealer was.
In 2008, the agency’s Division of Trading and Markets devised a Guide to Broker-Dealer Registration. It’s explained that the Exchange Act defines a dealer as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” That definition alarms many investors because taken on its face, it could apply to any investor. If so, a great many people could be forced to register with the SEC as dealers. Though concerns persist in some quarters, the SEC now emphasizes what’s known as the “trader exception”:
The definition of “dealer” does not include a “trader,” that is, a person who buys and sells securities for his or her own account, either individually or in a fiduciary capacity, but not as part of a regular business. Individuals who buy and sell securities for themselves generally are considered traders and not dealers.
The Guide adds several other attributes that may make one a dealer. Persons who do buy and sell securities “as part of a regular business,” and persons who hold themselves out as being willing to buy and sell a particular security on a continuous basis will likely need to register. Most toxic lenders do have “regular businesses”. Those businesses are staffed with at least a few employees. Some have even been found to employ cold callers to spend all day on the phone, trying to drum up custom.
The lenders want to keep their businesses because they are, for the most part, extremely lucrative. Although some of them are people who’ve played other roles in the financial industry, and are by now quite wealthy—Chicagoan John Fife comes to mind—others are just getting started. Ibrahim Almagarby quickly understood the ease with which he could enter the arena and started his own business when he was still a college student.
As luck would have it, the SEC chose Ibrahim Almagarby as the defendant in its first lawsuit against a toxic funder. Many similar suits have followed, but Almagarby filed an appeal that was closely watched. On February 14, 2024, the Eleventh Circuit upheld most of the lower court’s decision in the case. Though it threw out the penny stock bar the lower court had ordered, it was considered a victory for the agency.
SEC v. Carebourn Capital
On September 27, 2021, the SEC charged Carebourn Capital, L.P. and its managing partner Chip Alvin Rice of Maple Grove, Minnesota, with acting as unregistered dealers in “connection with their buying and selling of billions of newly-issued shares of microcap securities, or “penny stocks,” which generated millions of dollars for Carebourn Capital and Rice. Another Rice-controlled entity, Carebourn Partners, LLC, was also named as a relief defendant.
The complaint was issued in the U.S. District Court for the District of Minnesota, where Carebourn is located and where Rice lives. While it isn’t clear how long Carebourn has been in the toxic funding business, between January 2017 and July 2021, it purchased more than 100 convertible promissory notes from about 40 different microcap issuers located all over the country. During that time, Carebourn and Rice converted and sold more than 17.5 billion shares of stock, generated more than $25.8 million in gross sales, and netted over $13.9 million in profits. Many deals remained outstanding at the time the SEC brought its action.
Rice was a typical toxic funder. The complaint is careful to make clear that the defendants “operated a regular business through which they bought convertible notes—a type of debt security convertible into equity—for Defendants’ own account from penny stock issuers in need of cash.” It’s noted further that Carebourn and Rice “directly solicited penny stock issuers by cold calling them or meeting with issuer representatives at conferences. In these direct issuer solicitations, Defendants typically represented to issuer representatives that Defendants sought to invest in the issuer’s stock and explained the benefits of a convertible debt transaction.” Rice needed help managing his growing business, and hired helpers. One of them, a Maple Grove local called Mike Wruck, formed his own company, More Capital, LLC, and, the judge in SEC v. Carebourn explains, worked for Rice vetting new prospects in 2015-2016. Wruck in fact remained in the toxic funding business, and sued DarkPulse on June 29, 2021, the day Rice filed his own litigation against the company.
It’s likely many of the prospective clients they hustled were naive enough not to realize what they were getting into until it was too late. They also chose to approach microcaps with reliably high trading volumes that were current with their SEC filings. That way, they could be reasonably sure of being able to convert and begin to sell the resulting stock quickly as soon as the Rule 144 holding period expired. For reasons explained above, Rice usually converted his notes in several tranches.
The SEC explains that Carebourn’s profits were made possible by the large discounts to market it enjoyed upon conversion, not from any appreciation in the stocks’ price. It adds that “[t]his mechanism, which gave Defendants a spread or markup on the stock that they sold, is a common attribute of a securities dealer.”
Carebourne and DarkPulse
Examples of several of Carebourn’s transactions with issuers are offered to help explain precisely how the scheme worked. DarkPulse, Inc., the company represented by Mark Basile, is not one of them. The company, originally formed decades ago, has a subsidiary called DarkPulse Technologies Inc. which was a spinoff from the University of New Brunswick in New Brunswick, Canada. It still has connections with the university. Its business is developing security and monitoring systems that will initially be delivered in applications for border security, pipelines, the oil and gas industry and mine safety.
The effects of DarkPulse’s adventures with toxic funders can be seen in its 20 billion shares of authorized capital for its commons, with 8,100,117,720 shares issued and outstanding. Unsurprisingly, it is not yet profitable.
In its Form 10-K for fiscal year 2023, it explains its problems with Carebourn in some detail. Its troubles began in July 2018, when it signed stock purchase agreements in connection with the sale of two 12 percent promissory notes to Carebourn. We know from Carebourn’s original complaint in the matter that one note was for $189,750, and the other for $276,000.
As noted above, on June 29, 2021, Carebourn and Rice sued DarkPulse for breach of contract, as did Wruck and More Capital. On page 6 of the Carebourn complaint, “More” is used by accident when “Carebourn” is meant. Probably the complaints are identical, or nearly so. Though the Carebourn notes were originally fixed at 12 percent interest, they had a default interest of 22 percent. The contracts with Rice also required that DarkPulse reserve a certain amount of common stock in reserve “for the benefit and security of Carebourn as colleterial [sic] for the substantial loan given to DarkPulse.” Such reserve requirements are common in the world of toxic finance. Their real purpose is to make sure the funder will get his commons quickly when he seeks to convert his note.
According to Carebourn, by early 2021, DarkPulse had evidently stopped paying the interest due on its loans. It may also have been liable for other Default Events. Oddly, the complaint isn’t clear about exactly what DarkPulse had or had not done, though it asserts that should a Default Event occur, Carebourn would have the right to take “full control” of DarkPulse. It does make clear that the issuer had “refused to provide shares of stock pursuant to the conversion agreement.” Carebourn insists several more times that it “has full control” of the company, and adds for good measure that it wants Dark Pulse to pay its attorney fees as well.
Earlier in the complaint, Carebourn makes a point of saying that it “has not been recognized as a dealer under the Securities Exchange Act.”
Did Rice have reason to believe the SEC was planning to file against him? Nine months later, it did just that.
But not long after Carebourn filed its lawsuit against DarkPulse, it sought injunctive relief in the form of a temporary restraining order. It claimed that DarkPulse had failed to respond to the complaint. Rice wanted the judge to order DarkPulse to see to it that the stock owed to Carebourn would be reserved for it, pending resolution of the case. In support of its request, it notes piously that “[a]bsent an injunction DarkPulse may continue to issue shares to the public of questionable value.”
Shortly thereafter, Mark Basile entered an appearance on behalf of DarkPulse, along with his colleague Eric J. Benzenberg. The TRO was never granted, and attention shifted to attempts on the part of Carebourn to move the case to state court. DarkPulse had opposed the motion to remand the case, but the federal district court judge granted it nonetheless. Curiously, in a footnote, she observed that Carebourn alleges DarkPulse’s principal place of business is in Virginia, but that was disputed by DarkPulse, which claimed it was in New York but provided no confirmation. In fact, in 2021, DarkPulse gave its business address as 1345 Ave of the Americas, 2nd Floor, New York, NY 10105. That is the address of a 40,000-square-foot business center incorporating 115 offices and a number of meeting rooms. DarkPulse is now located in Houston, Texas.
In its objection to the remand, DarkPulse argued that the case belonged in federal court because Carebourn had and was violating the federal securities laws by acting as an unregistered dealer, and that question must be settled first. For its part, Carebourn sought relief in the form of a declaratory judgment that would support its contention that DarkPulse had breached the contractual agreements it had signed, and so Carebourn was entitled to take “full control” of the issuer. The judge pointed out that “such relief does not, on its face, arise under federal law. The judge was, however, even less convinced by DarkPulse’s argument: “Thus, although Darkpulse may seek to rescind the agreements [with Carebourn], either through a counterclaim or an affirmative defense, removal is not permitted on this basis… Therefore, Darkpulse’s contentions that Carebourn may be violating federal securities laws do not clearly establish a basis for federal-question jurisdiction.”
And so the case was remanded to state court.
The Latest Developments
Things moved slowly between 2021 and 2024. SEC v. Carebourne Capital has been making some progress, and perhaps more may be hoped for in the second half of the year. Once Carebourn had responded, it filed a motion for judgment on the pleadings. The arguments advanced were that the SEC had failed to state a claim and that the statutory definition of a “dealer” was so vague as to make any attempt to enforce its provisions a violation of the Due Process Clause.
Rice tried to lay claim to the “trader exception,” claiming he was just an ordinary guy, an everyday trader or investor. He protested that he wasn’t buying convertible promissory notes as part of a “regular business,” because he engaged in “arm’s length” agreements with the penny stock issuers he purchased them from. Of course, he had nothing to do with the clients! That’s where Mike Wurtz and his other dubious associates came in. Curiously, he protested that he never held himself out as willing to buy and sell a particular security. What, one wonders, was the reason for all that cold calling the SEC had become aware of?
On May 24, 2022, Judge Katherine Menendez denied Carebourn’s motion, demolishing his arguments along the way. She noted that Carebourn and Rice had a website at which Rice solicited penny stock issuers interested in convertible debt transactions, and added that Rice dumped the commons resulting from his conversions as soon as he received it. He’d also engaged in more than 100 transactions in a few years and had brought in gross profits of nearly $14 million.
On September 27, 2023, Judge Menendez issued a memorandum opinion and order designed to end the case. At the outset, she said bluntly:
Because the Court concludes that there is no genuine dispute that Defendants acted as dealers in violation of the statutory registration requirement, the SEC’s motion for summary judgment is granted, and the Defendant’s motion is denied.
She fully accepted the SEC’s interpretation of the definition of a dealer and had no doubt that Chip Rice was one. Interestingly, evidence produced in affidavits and court filings showed that he’d been a finance professional since 1987. It turns out he’d spent his early years in the business working as a registered rep at the notorious Blinder Robinson—known as “Blind ’em and Rob ‘em” back in the day—and RJ Steichen. He specialized in penny stocks. The disclosure events recorded at BrokerCheck aren’t especially lurid, but he did have a few problems before he quit working as a broker in 2009.
Carebourn was located in Rice’s home. For a few years, his son Logan and Logan’s company, Booski Consulting LLC, provided accounting and bookkeeping services to the company. Neither, however, had anything to do with soliciting penny stock issuers.
In her discussion of the case, Menendez presents familiar arguments and ties them to the law. She then grants the SEC’s motion for summary judgment and denies Carebourn and Rice’s motion for summary judgment. All that was left were a few loose ends that needed to be tied up.
On February 9, 2024, the SEC filed a motion for remedies. In it, the agency requested that the Court impose the following remedies against Carebourn Capital and Chip Rice:
(1) permanent injunctions as to both Defendants prohibiting them from further violating the federal securities laws as alleged in the Complaint; (2) permanent penny stock bars as to both Defendants; (3) order Defendants to pay, on a joint and several basis, disgorgement of net profits of $10,135,738.71, and prejudgment interest of $950,173.40, totaling $11,085,912.11; and (4) a civil penalty of $642,500 against each Defendant. The Court should also order Relief Defendant Carebourn Partners, LLC to pay disgorgement of $1,109,306.50, and prejudgment interest of $103,924.66, totaling $1,213,231.16, based on its receipt of ill-gotten gains from Defendants’ misconduct. Finally, the SEC requests that the Court order Defendants to surrender for cancellation shares of stock from, and conversion rights under, convertible notes that issuers sold to them.
The SEC motion was followed by a flurry of responses. A hearing on the motion was scheduled for July 22, 2024. At the beginning of the month, Mark Basile entered his appearance as an interested party on behalf of DarkPulse.
The DarkPulse case in state court had been referenced by Judge Menendez in a footnote to her opinion and order:
On April 21, 2023, Hennepin County Judge Patrick Robben granted DarkPulse’s motion for summary judgment, concluding in part that Carebourn acted as an unregistered dealer under Section 15(a)(1) of the Exchange Act… Although the SEC argued that the state court’s decision would have a preclusive effect upon the entry of a final judgment… the Court notes that the state court litigation appears to be ongoing, and the Court does not address the preclusive effect, if any, of Judge Robben’s decision.
On July 3, 2024, Mark Basile entered an appearance in Judge Menendez’s court as DarkPulse’s counsel of record, to ask that he be allowed to participate in the hearing. He first briefly outlined the state court case, encouraging the Court to agree that DarkPulse had been victimized by a toxic funder acting as an unregistered dealer. Since Menendez had obviously not been informed about the most recent news in the case, he provided the news she’d missed:
On November 17, 2023, the Minnesota State Court granted DarkPulse’s Motion for Partial Summary Judgment on its Minnesota Securities Act counterclaim. On December 26, 2023, a judgment was entered in DarkPulse’s favor and against Carebourn in the amount of $387,693.48 (the “Judgment”).
As of the date hereof, Carebourn has failed to (i) take a timely appeal and dispute the Judgment granted in DarkPulse’s favor and (ii) satisfy the amounts owed pursuant to the Judgment.
In reality, Carebourn and More did try to appeal their cases, seeking a review of the January judgment. Unfortunately for them, their appeal was far from timely. The appellate panel offered a brief chronology of the case, noting that DarkPulse argued that “the sixty-day deadline to appeal was Monday, February 26, 2024.”
The panel found that the appeal was untimely.
The hearing on the motion for remedies was duly held at the end of July. It was attended by attorneys for the SEC, attorneys for the defendants, and Mark Basile and Eric Benzenberg for “Interested Party Darkpulse, Inc.”
A transcript will be released to anyone who’d like a copy in 90 days, but in the meanwhile, Judge Menendez has left a teaser:
Counsel for Darkpulse, Inc. may file a letter brief of no more than 10 pages on or before 8/5/24. If Darkpulse files a letter brief, the SEC and Defendants may file any responsive letter brief, not exceeding 10 pages, on or before 8/19/24. Written order to be issued.
Basile’s brief is due in exactly a week. It will be brief in both senses of the word, but perhaps it will be punchier as a result. We’ll be ready to report on it when it appears.
For further information about this securities law blog, please contact Brenda Hamilton, Securities Attorney, at 200 E. Palmetto Park Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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