The SEC’s Amended “Dealer” Definition for Toxic Lenders
In the past five years or so, we’ve written many times about “toxic lenders”. These toxic lenders have been active since the end of the last century and have flourished providing financing to small publicly traded companies quoted by the OTC Markets. The kind of financing they offer is called “market adjustable” by the Securities and Exchange Commission and “toxic funding” or “death spiral funding” by many of its victims. The way it works is simple: the financier and the public company sign agreements binding each party to certain obligations and guaranteeing each party certain rights.
The public company will usually get money upfront. In return, the public company will issue market adjustable securities—a promissory note, preferred stock, warrants, debentures—to the toxic lender. The “market adjustable” part of the deal means that the securities sold will be convertible to common stock at a price that adjusts based on the public company’s trading price. Sometimes, the shares are registered with the SEC and can be sold immediately, and other times, the toxic lender can’t sell immediately because the convertible instrument will be subject to Rule 144, which means a holding period applies. The lender can’t sell for six months if the public company is an SEC registrant, or one year if it is not.
In a perfect world, these kinds of loans would be a great success for all involved: the public company, a startup, or at least a young company, would get the cash it needs in the short term and can use it to make more money, with which it could pay off the loan. In the end, the deal would cost him only a reasonable amount of interest.
But the world is not perfect, and this kind of financing comes with a catch. There is some risk for the toxic lender, because the value of the stock in question may be lower, not higher, when they seek to sell from the time the stock purchase agreement is signed. To compensate for this risk, the toxic lender will receive a large discount to the market price of the stock when he does convert and sell. The discount is usually between 40 and 50 percent but may be as high as 60 or 70 percent.
The reality is that the toxic lender runs very little risk. The discount he receives is how he makes money. The price at which he’ll convert may be based upon the stock’s lowest closing bid prices over a certain period often the preceding month. The discount will be applied to the conversion 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, usually dramatically. Worse yet, our toxic funder will soon sell another tranche of stock. This time, he’ll get even more discounted shares to dump, because the conversion price will be calculated from lower prices than before. This will continue until he’s converted all his toxic convertible notes or other securities and sold all the resulting shares. The public company may then need more cash. If so, it’s likely to return to him or someone like him to cut another deal.
Obviously, none of this is good for investors. The dilution—which will become even worse if the public company borrows from more than one toxic funder, as many do—may eventually force a reverse stock split. While reverse stock splits are theoretically neutral, reverse splits, in which the number of shares outstanding is reduced, while those shares’ value is proportionately increased, almost always turn out to be seriously damaging to investors. Often the stock loses a good deal of its new and higher price the day the split becomes effective. Within months, its price may be back to where it was before the split was announced.
What the SEC Has Done to Protect Investors and Public companies?
Since 2017, the SEC has brought nearly 20 lawsuits against toxic convertible note lenders. Its strategy is simple: it charges the toxic lenders with acting as unregistered dealers. In 2008, the SEC produced a “Guide to Broker-Dealer Registration” that explained when and why people who didn’t work for a brokerage might have to register as brokers or dealers. It defined a dealer as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”
While that sounds as if it could apply to ordinary investors, it does not, thanks to 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.
The definition makes clear that anyone who does buy and sell securities “as part of a regular business” may well be a dealer, and so required to register with the SEC. In addition, a person may be a dealer if he holds himself out as willing to buy and sell a particular security on a continuous basis, a person who runs a matched book of repurchase agreements, or a person who issues or originates securities that he also buys and sells.
In 2017, the SEC enforcement actions against toxic convertible note lenders increased. One early case was against Ibrahim Almagarby, who began his career not by buying convertible securities directly from public companies, but by purchasing “aged debt” from individuals who already owned convertible securities such as loans. He was a college student at the time but recognized an easy way to make money when he saw it. He could convert and sell his aged debt as soon as he purchased it, and the SEC argued that he was doing it “as part of a regular business.” Almagarby lost in Federal District Court but appealed to the Eleventh Circuit. On February 14, 2024, the appellate panel handed down an opinion that most commentators saw as a big win for the SEC. The lower court’s order had not only been challenged by Almagarby himself. Other interested parties made themselves known. The appellate panel noted that:
After Almagarby filed this appeal, two sets of amici curiae filed briefs in support of Almagarby. First, Trading and Markets Project, Inc., an industry group representing public and private funds, investment advisors, and others, filed a brief and participated in oral arguments as amicus curiae on behalf of Almagarby. Second, the Small Public Company Coalition, Alternative Investment Management Association, and National Association of Private Fund Managers filed an amicus brief.
The amici were not interested in Almagarby. They were concerned about the chance that the SEC might consider expanding its understanding of who is a dealer to include investment advisers and hedge funds, and urged the Court to consider “that statutory text, history, and context show that to be a “dealer” under the Exchange Act an entity must effectuate orders for customers as ‘part of a regular business,’ … rather than merely trade for investment purposes.”
The appellate panel disagreed:
To be clear, we do not mean to suggest that every professional investor who buys and sell securities in high volumes is a “dealer.” We acknowledge amicus’s concern that an expansive definition might sweep in all manner of market participants not traditionally understood as dealers, including investment advisors, mutual funds, pension funds, and other asset managers. But significant differences exist between Almagarby’s conduct and that of amicus’s investment advisor and fund members. For example, institutional asset managers do not rely on dilution financing or the rapid resale of microcap share issues as their sole source of income. Nor do they employ networks of finders to solicit microcap debtholders or operate without financial disclosures or regulatory oversight. Our holding that Almagarby operated as an unregistered “dealer” in violation of the Exchange Act is based on his specific conduct. And though Almagarby’s underwriting activity is certainly relevant to this determination, it is not the only factor on which we rely.
The Court rejected Almagarby’s contention that he’d been deprived of his constitutional right to due process, and his contention that the disgorgement of more than $885,000 ordered by the lower court judge was not “appropriate or necessary for the benefit of investors.” The Eleventh Circuit agreed with the SEC on all points but one: it reversed the penny stock bar applied to Almagarby because he had not committed deliberate fraud.
Toxic Convertible Note Lenders and Funders Fight Back
The defeat of the Almagarby appeal was seen by many as a big win for the SEC. However, the organizations represented by the amici and the people behind them were not finished. Public documents reveal many of those people were themselves toxic lenders. Some others were public companies that borrowed from toxic lenders.
The SPCC is a good example. It has an attractive website that offers some commentary. It’s also posted a few statements, most of them having to do with issues surrounding toxic funding. According to SPCC’s website and annual reports with the Commonwealth of Virginia, it’s headed by Mark Indeglia, a partner at Glaser Weil and co-chair of its Corporate Department. It was formed in Virginia in January 2021. According to his LinkedIn page and SEC filings, Chris Stalcup, its treasurer, is an employee of John Fife’s Chicago Venture Partners. Fife is a toxic lender who was charged with “acquiring and selling more than 21 billion shares of penny stock without registering as a securities dealer with the SEC.” The SPCC is represented by Helgi Walker of Gibson Dunn & Crutcher. Walker also represents Fife and other toxic financiers.
According to its website, part of the reason for the creation of the SSPC was a proposal to amend Rule 144. It would eliminate tacking for shares acquired upon exercise or conversion of market-adjustable securities. As explained above, generally Rule 144 stipulates a holding period of six months for securities sold pursuant to the Rule if the public company is an SEC registrant, and a holding period of one year if it is not. The holding period begins as soon as the purchaser of the convertible securities has paid for them. When the holding period expires, it expires for all of the securities, though their owner need not convert them all at the same time. In fact, it is common for toxic lenders to have an equity blocker clause in their agreement with the public companies preventing them from owning a greater-than-5-percent interest in it at any one time.
It can, however, convert and sell one tranche of stock, and, when he’s finished selling it, convert and sell another. Each time that happens, he gets more stock upon conversion. Needless to say, this is harmful to investors. And so, on December 22, 2020, the SEC proposed amendments to the Rule that would change how the holding period works. The changes would be simple, but effective:
Under the amendments, the holding period for the underlying securities acquired upon conversion or exchange of “market-adjustable securities” would not begin until conversion or exchange, meaning that a purchaser would need to hold the underlying securities for the applicable Rule 144 holding period before reselling them under Rule 144.
Then-chair Jay Clayton noted, “Today’s proposed amendments modernize, clarify and strengthen Rule 144, including to ensure that holders of market-adjustable securities are assuming the economic risks of their investment rather than acting as a conduit for an unregistered sale of securities to the public on behalf of an issuer.”
At the end of January, a group of 59 officers and directors of small public companies sent a comment to the SEC, saying in part:
By prohibiting tacking of the time between loan and conversion in calculating when the Rule 144 holding period has been satisfied, as the SEC proposes for loans to unlisted issuers, the SEC would significantly increase the risk to convertible lenders of making such loans. That added risk would be passed on to unlisted issuers and their shareholders in a variety of ways, driving up the cost of financing our businesses. Many convertible lenders would likely cease lending entirely to companies like ours, reducing the supply of capital and further increasing financing costs to the point that convertible loan financing would very likely become unaffordable to many issuers. This would in turn have a major negative effect on our businesses, resulting in the destruction of long-term shareholder value and putting some issuers out of business altogether.
The CEOs added:
Making rule changes that would cripple small and medium-sized public companies during a pandemic makes especially little sense because these convertible loans do not harm shareholders. These loans are typically publicly disclosed at the time the loans are made, so existing and potential shareholders are fully aware of the loans many months before there is any potential conversion. That gives potential shareholders the opportunity to decline to invest in companies that have received these loans, and existing shareholders the opportunity to sell their shares well before any potential conversion.
[Emphasis original]
They weren’t the only people who were upset. Helgi Walker and other lawyers from Gibson Dunn also sent a comment to the SEC. At 77 pages and many appendices containing exhibits, it is an unusually long example of the genre. After introducing a number of novel theories, Walker finishes with a flourish:
The SEC has failed to perform any meaningful analysis of the proposed rule, and instead has asked the public to conduct the studies for it. But it is the agency’s job to support its proposal. Nevertheless, the SEC has refused to produce the very data that members of the public have expressly requested—months in advance—to facilitate conducting the analyses the SEC itself has failed to do.
[…] The Commission should not proceed with the proposed rule, which will only harm small public companies and their investors. The Commission instead should support our nation’s smallest public companies as they seek the capital they need to grow into the American success stories of tomorrow.
Though nearly four years have passed, no final rule has been published, though the proposal remains on the SEC’s agenda.
The Enforcement Division’s cases against unregistered dealers continue to move through the courts. Some of the toxic lenders appear to have gone out of business. Others try to do what they’ve always done, creating a new company when needed to escape the SEC’s notice for a while. And those with deeper pockets may switch to doing PIPE (Private Investment in Public Equity) offerings.
On February 15, 2024, Mark Indeglia released a statement about the decision in the Almagarby appeal:
The Eleventh Circuit’s decision that Ibrahim Almagarby, a college student, was a “dealer” under the federal securities laws is a step in the wrong direction and only serves to further bolster this runaway Commission and its novel and radically expansive view of its authority. Mr. Almagarby, like so many others that the SEC has decided to target, was a small investor investing in small businesses under the widely-accepted understanding, in effect for decades, that his investment activity did not require registration as a broker-dealer.
SPCC members, as well as family offices, hedge funds, and even venture capital funds across the country, are now subject to regulation by enforcement under an entirely novel understanding of what constitutes a securities dealer. Small businesses, now more than ever, at risk of losing access to vital capital because investors simply do not want to risk engaging in onerous lawfare with the Commission.
The SPCC, in tandem with partners across various industries, stands ready to support a legislative solution to codify the definition of dealer as has been understood for decades and allow law-abiding market participants to inject capital where it is needed most: American small businesses.
We’d venture to say that not many people who’ve followed toxic funders over the last decade would agree that they’re just small investors, much less eager college students saving for the future. The fact that they dump their common stock as soon as they can is persuasive evidence of that.
The real reason for the concerns expressed by the SPCC and others in the financing business is a likely new SEC rule intended to define the term “dealer” once and for all, exempting certain kinds of market participants.
Redefining “Dealer”
As we’ve seen, since the SEC began taking “unregistered dealers” to court, many market participants who don’t buy and sell market adjustable securities have been concerned that the SEC might come after them. Among them are investment advisers, hedge funds, and more. In the hope of clarifying the old definition of a dealer and also clarifying the matter of who is not a dealer, on March 28, 2022, the SEC published a proposed rule and invited comment.
First of all, the proposed rule would add a new category of potential dealers to the mix: government securities dealers, which, of course, are people or entities that sell government bonds. They’re sometimes neglected in discussions that proceed from questions involving equity securities. Readers may remember that a couple of months before the compliance date for the amendments to Rule 15c2-11 arrived, someone realized the rule makers had forgotten to include bonds. Adjustments were made, and solutions were found. The matter was settled fairly quickly. But it seems likely no one at the SEC wanted to see it happen again.
A final rule appeared on February 29, 2024, and was adopted at what was described as a “contentious” open meeting of the SEC on February 6, 2024. It became effective on April 29; the compliance date is April 29, 2025. The vote to adopt split along party lines, with Chair Gary Gensler, Caroline Crenshaw, and Jaime Lizárraga voting for, and Hester Peirce and Mark Uyeda voting against.
The proposed rule was met with a considerable number of comment letters, most of them unfavorable. Virtu Financial felt that “the proposal fails to identify a market failure that needs to be addressed.” One of the chief features of the new rule is that some liquidity providers may be considered to be “de facto market makers.” Virtu feels there’s nothing wrong with providing liquidity, and does not see why any definition is needed.
SIFMA Asset Management Group’s response was also highly unfavorable. The organization felt, like Virtu, that much of the proposal addressed largely nonexistent problems with solutions that might be burdensome for the entities and individuals expected to comply with them. The Blockchain Association felt the rule might be applied to digital assets inappropriately; a real danger given that regulations governing those assets are in their infancy. It concluded by saying that the proposal exceeds the SEC’s statutory authority and contradicts prior SEC guidance. The Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association pointed to legal weaknesses and ambiguity in the rule. Nearly all the other comments were in the same vein.
The final rule took nearly two years and was not well-received. Upon adoption, Gary Gensler remarked cheerfully, “These measures are common sense. Congress did not intend for registration and regulatory requirements to apply to some dealers and not to others. Absent an exemption or exception, if anyone trades in a manner consistent with de facto market making, it must register with us as a dealer – consistent with Congress’s intent.”
Hester Peirce did not agree. In a long statement, she explained that the new “definitions” contradict everything that had been believed about the activities of “dealers” and “traders”:
The rule the Commission is considering today obliterates this distinction by extending the definition of “dealer” to market participants that run investing and trading businesses, not dealing businesses. Rather than looking to whether the “regular business” of the firm bears the hallmarks of dealing activity, today’s rule would capture any person whose “regular business” involves trading activity for its own account that provides liquidity on a more than “incidental” basis. Although the Commission and its staff have previously stated that liquidity provision may be indicative of dealing activity, it has not to my knowledge ever before stated categorically that liquidity provision alone by a person trading for its own account constitutes dealing activity or that trading activity becomes dealing activity merely because it has the effect of providing liquidity.
K&L Gates, a Delaware law firm, has produced a thoughtful and useful paper explaining the differences between the proposed and final SEC rules and offers guidance on what kind of individual or firm might be required to register as a dealer. The SEC has already said it’s identified “up to” 43 entities that may be affected by the final rule and, therefore, required to register. The law firm, however, believes the impact may be greater, especially in the bond markets. It agrees with Peirce and SEC Trading and Markets Director Haoxiang Zhu that it may be difficult to resolve difficulties that arise involving digital assets. The final rules still exclude persons that have or control assets of less than $50 million, investment companies registered under the Investment Company Act of 1940, central banks, sovereign entities, and international financial institutions.
The SEC continues to bring enforcement actions against the toxic funders with whom we’re so familiar. The new definitions of “dealer” and “regular business,” will not change the regulator’s attitude toward them. In August 2024, Commissioner Uyeda took the occasion of successful cease-and-desist proceedings against GHS Investments, LLC, Mark S. Grobee, Safraz S. Hajee, and Matthew L. Schissler to discuss what he sees as “regulation by enforcement.” His colleague Hester Peirce has long felt the same way about actions brought against crypto companies that are unsure what they can and cannot do because regulation in their world is still undeveloped.
Uyeda went so far as to dissent from the order—even though the respondents had struck a settlement agreement with the SEC—because he objected to the way the SEC handled the case. His point of view is mostly practical:
Prior to 2017, investors in convertible, variable rate notes had no reason to believe that their activity could trigger dealer registration obligations. One might claim that market participants should have been on notice about the SEC ’s previously undisclosed interpretation of “dealer” when it filed the first complaint in 2017. However, it is unreasonable to expect market participants to be continuously scanning court dockets in pending litigation across the country for new legal theories from the SEC, and on which a court has never ruled.
[…] As the SEC acknowledges in its order, GHS ceased purchases of new convertible, variable rate notes in 2020, and converted and sold only small amounts of stock from existing inventory after 2020. In other words, GHS stopped the conduct in question around the time that the first judicial opinions stating that such conduct triggered dealer registration requirements was issued. In light of this, holding GHS to a standard not articulated until after its conduct occurred is fundamentally unfair.
Rather surprisingly, Uyeda does not object to the proposed changes to Rule 144 decried by so many toxic lenders. He, in fact, recommends that the “Commission should achieve its objectives through the rulemaking process, such as its proposal to change Rule 144’s tracking requirements.” He notes as well that GHS was not only involved in adjustable rate convertible notes but also acquired discounted common stock through equity lines of credit, and then once they were registered with the SEC, sold them at market prices.
Uyeda asks, reasonably enough, why the SEC treats the purchase of adjustable-rate convertible notes differently from increasingly popular discounted commons provided by an equity line of credit. He also asks whether its implementation of the Exchange Act’s “dealer” definition should be analyzed under the Supreme Court’s “void for vagueness” doctrine, which “addresses at least two connected but discrete due process concerns: first, that regulated parties should know what is required of them so they may act accordingly; second, precision and guidance are necessary so that those enforcing the law do not act in an arbitrary or discriminatory way.”
But that, and a closer look at equity lines of credit, is a discussion for another day.
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.
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