Xeriant, Inc. Fights Toxic Funder Auctus Fund in Appellate Court

Since 2017, the SEC has been bringing enforcement actions intended to curb the excesses of lenders who deal in convertible securities like promissory notes, preferred stock, warrants, debentures, and more. While the word “lenders” seems anodyne or even beneficial, these individuals and the businesses they run have come to be known to issuers and investors as “toxic lenders” or “toxic funders.” The SEC calls them “unregistered dealers,” as defined in its own Guide to Broker-Dealer Registration. Most of the companies that agree to the financings they offer are OTC or Nasdaq CM issuers.

The Commission’s actions against unregistered dealers began in November 2017, with a suit brought against Ibrahim Almagarby and his Microcap Equity Group LLC. Unlike most of his fellow lenders, Almagarby didn’t initially deal with the companies whose convertible securities he was converting and selling into the market. He instead bought “aged debt” purchased from unaffiliated third parties. Aged debt is old enough to be exempt from the registration requirements of the Securities Act of 1933 under Rule 144. As the eventual appellate opinion explained, “[m]any of the instruments he purchased did not have an existing conversion feature. So Almagarby negotiated directly with the issuers to obtain agreements that allowed him to exchange existing, non-convertible debt for convertible instruments.”

Those agreements gave Almagarby immediate conversion rights. Since he had no holding periods to observe, he simply sold his converted stock into the market, usually in tranches. The selling pressure he exerted caused the stocks’ prices to drop, but he was able to sell quickly in most cases. The SEC alleged in its complaint that:

Between January 2013 and July 2016, Defendants entered into 57 other debt purchase agreements via which they acquired more than $1.1 million in aged debt convertible securities from 38 other microcap issuers. Defendants converted the securities into more than 8.9 billion shares of microcap stock, more than 7.4 billion of which they sold into the market, reaping a gain of $1,474,901.63.

The plan, which Almagarby put into operation while still in college, was simple, effective, and lucrative until the SEC decided to charge him as an unregistered dealer under the Exchange Act of 1934. The remedy the SEC sought for his violations of the securities laws was harsh: “permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest, civil penalties, surrender for cancellation of MEG’s remaining shares in the penny stock issuers that are the subject of this action and surrender of any conversion rights in its remaining holdings of issuer debts, and penny stock bars.” That meant his agreements with all the issuers he was involved with would be null and void, and any stock he’d converted in preparation for selling into the market would be cancelled. 

The Commission brought a number of similar suits against toxic lenders in the following years. They were in some ways different from the Almagarby litigation because the defendants were, for the most part, more sophisticated. Almagarby simply converted stock and dumped it as fast as he could. He had only one shot at increasing his potential for greater gain, which was his greater or lesser success in negotiating a favorable conversion rate with the issuer. 

The real “lenders” who came to the SEC’s attention actually gave the companies they worked with money, and so they had a much stronger hand to play. They approached, or were approached by, an issuer in need of cash. They and the company then negotiated a Stock Purchase Agreement and several collateral documents. One of the most important features of the completed agreement was the conversion ratio that would come into play when the lender decided to sell. Because they’d be subject to risk in the form of a Rule 144 holding period—six months for the stock of SEC registrants and one year for non-filers—they would be allowed to convert at a discount to the stock’s market price. This discount could be as large as 60 percent of the stock’s average bid price for the past 30 days. 

The lenders rarely converted and sold all their holdings at once. They wanted to avoid depressing the stock price excessively, especially at the outset, and they also wished to keep their holdings below 5 percent. Exceeding that limit would require them to file as company affiliates. They would convert a large, but not too large, chunk of stock and then sell it in several tranches over a period of weeks. Then, they’d wait for the stock to settle before converting again. By that time, the stock price would almost always have declined, thanks to the dilution. As a result, the lenders would get a more favorable conversion rate the second time round, which guaranteed them more stock upon conversion.

The conversions and sales would continue. If more than one toxic lender were involved, which was often the case, the stock price decline would proceed at an even faster pace. That is why these are called “death spiral” financings. Eventually, the issuer, still desperate for cash and unable to convince investors to buy an offering, would feel he needed to make a new deal with the financier. The next step would be a big reverse split or, in some cases, bankruptcy.

In the years following the initiation of the Almagarby litigation, the SEC has gone up against a number of these toxic funders: Joshua Sason, Mark Manuel, Kautilya (a.k.a. Tony) Sharma, Perian Salviola, et. al. in 2019; John M. Fife and five of his companies in 2020; Justin Keener d/b/a JMJ Financial in 2020; John D. Fierro and JDF Capital, Inc. in 2020; Crown Bridge Partners, LLC, Soheil Adhoot, and Sepas Adhoot in 2022; Aryeh Goldstein, Adar Bays, LLC, and Adar Alef, LLC in 2024; Curt Kramer and Power Up Lending Ltd. in 2024, and quite a few more. 

Every case was based on the SEC’s interpretation of the definition of a dealer as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise,” based on the provisions of the Securities Exchange Act of 1934. In its Guide, the agency offers a number of reasons why an individual or enterprise might have to register as a dealer, but one is more important than the others, and it appears in every lawsuit the Commission has filed against unregistered dealers. 

While the SEC says a dealer is anyone in the business of buying and selling securities, it recognizes that is far too broad, as it would include all, or nearly all, investors. And so it’s come up with what’s called 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.

[Emphasis ours.]

The SEC alleged that Almagarby and all the other toxic lenders were engaged in “a regular business” from which they profited greatly. Most of the cases in question were not resolved quickly, largely because of the COVID pandemic, but once the courts got moving again, the SEC won judgment after judgment. 

The lenders are not simply accepting their fate, registering as dealers, or moving on. They have no wish to lose their lucrative businesses. Many have fought hard in federal district court, and some have carried that fight to appellate court. One of them was Almagarby. There was a good deal of interest in the case because other lenders were alarmed, knowing they could be next, and because market participants conducting business that did not involve convertible securities feared they could nonetheless be considered “dealers.”

Several groups who deal with those concerned market participants filed amicus briefs in the appeal. One was the Trading and Markets Project, represented by Jenner & Block, which wanted the judges to understand that participants like investment funds have investors, not customers, and so cannot be considered dealers. The Small Public Company Coalition, the Alternative Investment Management Association and the National Association of Private Fund Managers hired law firm Gibson, Dunn & Crutcher to represent their interests. Gibson Dunn criticized the SEC for attempting “a radical, transformative expansion in the commission’s authority” and asserted that “vast regulatory overreach” would subject “virtually every business that participates in the securities markets” to reporting requirements and potential exposure to liability as a securities broker.”

The appellate panel delivered its opinion on February 14, 2024. Almagarby would not have considered it a Valentine. The panel concluded that “Almagarby was a ‘dealer’ under the Exchange Act and disgorgement was an appropriate remedy, but that the district court abused its discretion by imposing the penny-stock ban. We therefore affirm in part and reverse in part.”

The SEC was satisfied and took it as a win.

So far, SEC enforcement cases against unregistered dealers have resulted in five wins with various penalties and injunctive remedies:

• In the SEC vs JOHN D. FIERRO, et al., Civil Action No. 20-02104 (GC) (JBD), the court ordered the defendants to pay disgorgement of $4,053,148, prejudgment interest of $1,326,440, and a civil penalty of $500,000, for a total judgment of $5,879,588. The court also ordered the defendants to surrender certain stock and conversion rights under existing convertible securities for cancellation. (read more here)
• In the SEC vs GPL VENTURES LLC, et al., 21-cv-6814 (AKH), the court ordered the defendants to pay $29,681,569 in disgorgement and $2,489,799 in prejudgment interest, total civil penalties of $7,000,000 and directed the defendants to surrender for cancelation all remaining unconverted convertible notes still held, with a face value of approximately $11 million. (read more here)
• In the SEC vs BHP CAPITAL NY, INC. and BRYAN PANTOFEL, Case No. 1:23cv22233-GAYLES-TORRES, the court ordered the defendants to pay a total of $2,553,073.44 in disgorgement, prejudgment interest, and penalties and directed the defendants to surrender for cancellation and retirement all remaining warrants, shares, and conversion rights on convertible notes still held by the defendants.
• In the SEC vs. IBRAHIM ALMAGARBY and MICROCAP EQUITY GROUP, LLC, Case No. 17-62255-CIV-COOKE/HUNT, the court ordered the defendants to disgorge $885,126.30 in total net profits and $182,150.69 in prejudgment interest, for a total of $1,067,276.99. The court also ordered the defendants to surrender their remaining shares for cancellation. (read more here)
• In the SEC vs JUSTIN W. KEENER, d/b/a JMJ Financial, Case No. 20-cv-21254-BLOOM/Louis, the court ordered the defendant to pay disgorgement of $7,786,639, prejudgment interest of $1,425,266, and a civil penalty of $1,030,000, for a total judgment of $10,241,905.  The court also ordered the defendant to surrender for cancellation all stock and conversion rights under existing convertible securities. (read more here)

The courts also denied Carebourn Capital, L.P.’s Motion for Judgement on the Pleadings to dismiss the SEC case filed against that penny stock financier in the Securities and Exchange Commission v. Carebourn Capital, L.P., et al., Civil Action No. 21-cv-02114 (D. Minnesota filed September 24, 2021). That case is in the final stages, with the two sides hacking out remedies for a settlement.  The final judgment in the SEC’s favor could come any week now. (read more here)

Public companies who’d accepted toxic funding and experienced its deleterious effects followed the growing number of SEC lawsuits and subsequent wins with interest. Some took action, realizing it might be possible to have their lenders’ converted shares cancelled and their stock purchase agreements voided. One of those companies is Xeriant, Inc.

Xeriant 

Over the years, toxic funders regularly sued their own victims, saying they had, among other things, defaulted on their convertible debt. And they regularly won. In 2016, for example, Curt Kramer’s KBM Worldwide filed against Hangover Joe’s Holding Corp. Initially, Hangover Joe’s tried to fight, but it lacked the resources and was also being sued by several other toxic funders. It lost those suits, the last winding up in 2019.

But the tide seems to be turning. Xeriant is now taking on Auctus Fund. Auctus has long been one of the most prominent of the toxic lenders. Auctus’s website is almost comically uninformative. We learn only that:

Auctus Fund Management is a private asset management firm focused on preserving and enhancing our clients’ wealth by investing in alternative investments.  The firm’s principals share a long history in structured investments and the capital markets. 

Our philosophy is to deliver returns over time that are superior to equity markets and are generally uncorrelated. 

Our principals represent a significant amount of the firm’s assets under management. We believe our strong performance is a function of our consistent investment philosophy and process which drives all our decisions.

All other links suggest that the reader fill out a form requesting further information. We aren’t even told who the firm’s principals are, but their identities are revealed elsewhere. That’s in part because the SEC sued Auctus and its principals, Louis Posner and Alfred Sollami, in June 2023. (read more here)

The complaint alleges that Auctus acted as an unregistered dealer:

By engaging in a regular business of buying convertible notes, converting the debt into stock at a large discount, and selling the newly-issued shares of stock into the public U.S. securities markets, the Defendants operated as unregistered securities dealers. Auctus did so under the direction of Sollami and Posner, who developed this business model for Auctus, who had final authority over Auctus’s business decisions, and who failed to register or to associate themselves with a registered dealer.

In violating the dealer registration requirements of the federal securities laws, Defendants avoided regulatory obligations for dealers, including submitting to inspections and oversight by the Commission, following financial responsibility rules, and maintaining required books and records in accordance with applicable regulatory requirements.

Elsewhere, the government notes that between 2017 and 2021, Auctus acquired and sold more than 60 billion stock shares, generating more than $100 million in gross stock sale profits. 

The case has not yet progressed beyond its early stages, but a number of familiar faces have joined in the fight. Auctus is represented by Greenberg Traurig and Gibson Dunn, as are Posner and Sollami. The Alternative Investment Management Association, Ltd, the National Association of Private Fund Managers, and the Trading and Markets Project, Inc. have filed amicus briefs and are all represented by Jenner & Block.

Auctus also faces problems on another front. On October 19, 2023, Xeriant filed suit against the firm in the Southern District of New York. Xeriant was represented by the Law Office of William Igbokwe. On February 9, 2024, Judge Lewis A. Kaplan issued an order. 

Xeriant alleged that when it engaged in its transaction with Auctus, Auctus had acted as an unregistered dealer. Xeriant’s objective was for documents associated with that transaction to be rescinded. Auctus replied that the Exchange Act allegations—the ones having to do with whether it had acted as an unregistered dealer—were barred by the statute of limitations and added for good measure that they failed to state a claim. Judge Lewis ruled that the statute of limitations argument was without merit but was much more supportive of Auctus on the question of whether or not it acted as a dealer:

The substantive reach of Section 29(b) is another matter, [sic] Assuming arguendo that Section 29(b) gives rise to a private right of action to void an agreement, the plaintiff would be required to allege facts demonstrating that the agreement the plaintiff seeks to void obligated the defendant to act as a dealer. […] The complaint alleged no such facts. Plaintiffs [sic] contention that the agreement at issue may be voided on the theory that it permitted defendant to continue a practice that plaintiff regards as inconsistent with the objective of the Exchange Act registration provision and therefore is reachable under Section 29(b) is unsupported by authority and unpersuasive.

He added that “[a]s defendant points out, plaintiff has not sought to defend the sufficiency of its state law claims, which therefore are dismissed.”

Xeriant filed a notice of appeal and took the case to the U.S. Court of Appeals for the Second Circuit. There, the company is represented by Mark R. Basile and Marjorie Santelli of the Basile Law Firm. 

The appellate brief first states the issue presented for review:

May an unregistered securities dealer purchase the Convertible Promissory Note in this case without violating Section 15(a) of the Securities Exchange Act of 1934?

Short Answer: No. Under §15(a) of the Exchange Act, it is unlawful for an unregistered securities dealer “to effect any transactions in … any security. Because a convertible promissory note is a security, an unregistered securities dealer “effects a transaction in securities” when he purchases the note, or enters into a contract to purchase the note.

It goes on to explain the SEC enforcement actions of recent years, emphasizing the importance of the Almagarby appellate decision. It quotes a bit of the decision, in which the panel wrote, “The process of acquiring new shares from an issuer ‘for the purpose of reselling them’ is quintessential dealer activity.” Once the holding period has expired, he converts and sells quickly to profit from the spread between the discount and the market price. It is then explained how this “death spiral” funding damages issuers.

The brief then turns to a key point for Xeriant, advancing the claim that the SDNY has its own interpretation of the circumstances under which a party may succeed with a recession claim:

The SDNY formulation arbitrarily excises half of the statutory language providing that contracts “shall be void” — not just where performance would violate the Act, but also those contracts made in violation of the Act. An analysis that looks to performance only, to the exclusion of contract formation, is contrary to the plain language of the statute, contrary to every Circuit Court to render a decision on this issue, and contrary to the clear guidance of the United States Supreme Court. Furthermore, the requirement that the contract must obligate the unregistered dealer to “act like a dealer” has no basis whatsoever in this statute.

To support Xeriant’s argument, the terms of its transaction with Auctus—not discussed in any detail in the original complaint—are described fully. The “loan” was a big one for a small company, intended to finance the acquisition of XTC Aircraft Company. According to the agreement signed by the parties, Auctus loaned Xeriant $5,142,500 through the purchase of a convertible “Senior Secured Promissory Note” in the amount of $6,050,000 and a stock purchase warrant for 50,968,828 shares, with a strike price of $0.11 a share. After the deduction of a discount and various fees, Xeriant received a total of $4,708,950. 

The note was convertible into Xeriant stock “at the lesser of (i) $0.1187 or (ii) 75% of the offering price per share of Common Stock” of the “uplist” that would occur when the merger with the acquisition target was reached. (Currently, XERI trades at or a little below $0.02; it hasn’t been above $0.1187 since early 2022.)

Far more sinister is one of the default events: if Xeriant failed to acquire all the equity interests in its acquisition target within eight months of October 21, 2021. Nearly all the agreement’s other provisions were unfavorable to Xeriant.

Unfortunately, the proposed acquisition and merger fell through, and in December 2023, Xeriant sued XTC for breach of contract. A few months earlier, Auctus had begun submitting conversion notices for enormous amounts of stock.

Two cases similar to Xeriant’s had been heard in the SDNY, in which companies called ExeLED Holdings Inc. and Vystar Corp tried to sue the toxic funders with whom they dealt. The Xerient appellate brief contends that the cases were not well-argued, and so the courts were never told that convertible notes were securities. Both companies lost, and both cases are now being cited as precedent for the district. When this case—the Xeriant case—was heard in the district court, the presiding judge noted that “‘the precedent in this district’ and rejected the claim because ‘the agreement that plaintiff seeks to void’ does not ‘obligate the defendant to act as a dealer.’”

Citing a Fifth Circuit case called Eastside Church of Christ v. National Plan, Inc., in which the church sued for recission of certain bonds, the court held that:

Under §15(a)(1), National was prohibited from effecting the transactions here involved, and thus violated the Act by entering into those transactions. Under the voiding provision of §29(b), it is sufficient to show merely that the prohibited transactions occurred and the appellants were in the protected class.

In other words, the Fifth Circuit found the contract to be void and unenforceable. While some still seem to consider Eastside Church an outlier, the Eleventh Circuit discussed it approvingly in its recent opinions in Almagarby and Keener.

Xeriant has argued its case well and has clearly shown that Auctus violated the securities laws when it entered into its convertible financing transaction. For good measure, it adds that the Second Circuit has “long recognized the right of an innocent party to bring an action for rescission under Section 29(b) to void a contract made or performed in violation of the Exchange Act of 1934.”

We wish Xeriant well. If it prevails—which is not guaranteed—its victory will help not only the company but also its investors. It may also help investors in other companies that have suffered at the hands of toxic lenders. 

To speak with a Securities Attorney, please contact Brenda Hamilton 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.

Hamilton & Associates | Securities Attorneys
Brenda Hamilton, Securities Attorney
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