SEC Pursues Unregistered Dealers, Toxic Financing, Toxic Convertible Notes
2020 and 2021 have been historic years for Securities and Exchange Commission (“SEC”) enforcement action against toxic lenders as unregistered dealers. We recently wrote about the interesting SEC enforcement actions that examine toxic financings and the question of whether the individuals and entities that purchase convertible promissory notes from public companies are “dealers” according to the definition established in Section 15(a)(1) of the Securities and Exchange Act of 1934 (“Exchange Act”).
Informally known as “toxic lenders” or “dilution funders” because the terms of their financing agreements contain provisions that almost always result in harm to investors and issuers alike, they’re considered by many to be the scourge of the penny stock market. Typically, the notes they buy can be converted at any time, often at a discount to market price of 70 percent or more. As the lender converts and sells, stock price drops. To avoid making insider filings to the SEC, the lender’s financing agreements specify that he may own no more than 4.99 percent of the company’s stock at any time. But that in no way stops him from converting his note continuously, in a succession of tranches. Since the conversion ratio is pegged to the security’s recent average bid price, every time he converts, he gets more stock than the time before. As he sells tranche after tranche, the company’s stock price enters freefall. Sometimes the only remedy for the issuer is a large reverse split.
The SEC has made clear it believes these toxic funders are indeed dealers, and as such must register with the agency and join a self-regulatory organization (“SRO”). In this case, the relevant SRO would be the Financial Industry Regulatory Authority (“FINRA”). Should they continue their activities without registration, those activities will violate the securities laws. In addition, their financing agreements will be void under 15 U.S.C. § 78cc(b) and Section 29(b) of the Exchange Act.
- On February 20, 2020, the SEC filed an enforcement action against John Fierro and JDF Capital (SEC v. John D. Fierro and JDF Capital, Inc.).
- On March 24, 2020, the SEC filed an enforcement action against Justin Keener and JMJ Financial (SEC v. Justin W. Keener, d/b/a JMJ Financial).
- On September 3, 2020, the SEC filed an enforcement action against John M. Fife and five entities he owns and controls: Chicago Venture Partners, L.P., Iliad Research and Trading, L.P., St. George Investments LLC, Tonaquint, Inc., and Typenex Co-Investment, LLC (SEC v. John M. Fife, Chicago Venture Partners, Iliad Research and Trading, St. George Investments, Tonaquint, and Typenex Co-Investment).
And in the middle of the three actions, on August 17, 2020, the SEC won a summary judgment against Ibrahim Almagarby and his company, Microcap Equity Group, LLC, which sets the precedence for the three suits mentioned above as well as any new actions against toxic lenders in the future.
The recent ruling in the SEC action against Ibrahim Almagarby and Microcap Equity addresses unregistered dealer activity by businesses engaged in the purchase of notes and/or bonds convertible at a discount to the market price of the underlying security. These types of transactions are most often the result of toxic note financings provided to penny stock companies; they sometimes feature conversion ratios as dramatic as an 80 percent discount from the issuer’s trading price.
SEC v Ibrahim Almagarby and Microcap Equity Group LLC
In its complaint, the SEC alleged that Almagarby and Microcap Equity acted as “dealers” without registering with the SEC, as both brokers and dealers are required to do under the Securities Exchange Act of 1934.
During the period relevant to the SEC charges, Ibrahim Almagarby was a 29-year-old college student who formed Microcap Equity Group in January 2013. Microcap Equity’s business model was to acquire “aged debt” owned by third parties in a variety of microcap issuers. He’d negotiate a debt purchase agreement with the note holder to acquire the debt at face value. “Face value” did not, of course, include the hefty discount to market he’d receive when he converted. At the same time, he’d negotiate an agreement with the issuer, by the terms of which he would be permitted to convert the note to “free trading” stock immediately.
The issuer’s transfer agent would issue unrestricted stock and deposit in one of the six trading accounts in the name of Microcap Equity he used for that purpose. Upon receipt, he’d sell the stock into the public market as soon as possible.
During the relevant period, Almagarby and Microcap Equity engaged in convertible note transactions with at least 38 different issuers.
The complaint charged Almagarby and Microcap Equity with violating Section 15(a) of the Exchange Act by acting as unregistered securities dealers.
“Section 15(a) makes it unlawful, inter alia, for an unregistered dealer to purchase or sell securities. Section 3(a)(5)(A) of the Exchange Act defines dealer as “any person engaged in the business of buying and selling securities . . . for such person’s own account through a broker or otherwise.” Section 3(a)(5)(B) excludes from the definition of dealer any “person that buys and sells securities . . . for such person’s own account, either individually or in a fiduciary capacity, but not as part of a regular business.” This statutory exception from the definition of dealer is typically referred to as the trader exception. Section 3(a)(5) does not enumerate any specific activities that separate a dealer from a trader; when read together, the two subsections of the statute simply require that those who buy and sell securities as part of a “regular business” must register with the Commission as securities dealers.”
This Court states that the issue of unregistered dealer activity by Almagarby and Microcap Equity turns on whether Microcap Equity is engaged in the “business of” buying and selling securities for its own account. It notes that business is defined as “[a] commercial enterprise carried on for profit, a particular occupation or employment habitually engaged in for livelihood or gain.”
The Court also states that the number of deals and the profit Almagarby and Microcap Equity generated gives credence to the proposition that they were engaged in the “business” of buying and selling securities. SEC v. Ridenour, 913 F.2d 515, 517 (8th Cir. 1990), (defendant “was a dealer because his ‘high level of activity . . . made him more than an active investor’.”) Taken together, it is indisputable that Defendants were “in the business of. . .buying [and] selling securities. . .” and, therefore, they do not meet the § 4(1) exemption to the registration requirement. SEC v. Offill, Case No. 3:07-CV-1643-D, 2012 WL 246061 at *8-9 (N.D. Tex. Jan. 26, 2012) (granting summary judgment on a Section 15(a) claim for failure to register and holding that the defendant “bought and sold securities as part of his regular business, making him a dealer under 15 U.S.C. § 78c(a)(5)”).
It was no suprise that the SEC’s summary judgment motion as to Almagarby’s unregistered dealer activity was granted earlier this year.
SEC v John Fierro and JDF Capital
In its complaint, the SEC alleges that from at least January 2015 through November 2017 (“the Relevant Period”), Fierro and his wholly-owned company, JDF Capital, bought and sold billions of newly issued shares of microcap securities (i.e., penny stocks), generating millions of dollars from those sales—but failed to comply with the mandatory dealer registration requirements of the Federal securities laws.
Fierro admitted that his and JDF’s business model was buying convertible notes from penny stock issuers, converting the notes into newly issued shares of stock, and selling those shares into the public market at a profit. During the Relevant Period, Fierro and JDF purchased or converted more than 50 such notes from more than 20 different microcap issuers, demanding and receiving highly favorable terms for these notes, including deep discounts from the prevailing market price.
By engaging in a regular business of buying convertible notes and selling the resulting newly issued shares of microcap stock into the public market, Fierro and JDF operated as unregistered securities dealers and generated more than $2.3 million in profits.
By failing to comply with the dealer registration requirements of the Federal securities laws, the SEC claims that Fierro and JDF violated Section 15(a)(1) of the Securities Exchange Act of 1934 by acting as unregistered securities dealers.
The SEC is requesting, among other things, that the Court enjoin Fierro and JDF from committing further violations of the Federal securities laws as alleged in this Complaint and order them to pay disgorgement and a monetary penalty based upon these violations.
The case has stalled in the court, but it should be noted that on August 31, 2020, the SEC submitted their summary judgment against Almagardy and Microcap Equity and the court’s order denying Justin Keener and JMJ Financial’s motion to dismiss, proving just how closely tied the rulings in all of these cases are.
SEC v Justin Keener and JMJ Financial
In its complaint, the SEC alleges that from at least January 2015 through January 2018, Justin W. Keener d/b/a JMJ Financial bought and sold billions of newly issued shares of microcap securities (i.e., penny stocks), generating millions of dollars from those sales—but failed to comply with the mandatory dealer registration requirements of the Federal securities laws.
Keener admitted that his business model was buying convertible notes from penny stock issuers, converting the notes into newly issued shares of stock, and selling those shares into the public market at a profit. During the Relevant Period, Keener purchased or converted more than 100 such notes from more than 100 different microcap issuers, demanding and receiving highly favorable terms for these notes, including deep discounts from the prevailing market price.
By engaging in a regular business of buying convertible notes and selling the resulting newly issued shares of microcap stock into the public market, Keener operated as unregistered securities dealers and generated more than $21.5 million in profits.
By failing to comply with the dealer registration requirements of the Federal securities laws, the SEC claims that Keener violated Section 15(a)(1) of the Securities Exchange Act of 1934 by acting as unregistered securities dealers.
The SEC is requesting, among other things, that the Court enjoin Keener from committing further violations of the Federal securities laws as alleged in this Complaint and order them to pay disgorgement and a monetary penalty based upon these violations.
The case is ongoing, but in an important ruling, the Court denied Keener’s motion to dismiss August 14, 2020.
SEC v John Fife, Chicago Venture Partners, Iliad Research and Trading, St. George Investments, Tonaquint, and Typenex Co-Investment
In its complaint, the SEC alleges that from at least January 2015 through the present, John M. Fife and five entities he owns and controls Chicago Venture Partners, L.P., Iliad Research and Trading, L.P., St. George Investments LLC, Tonaquint, Inc., and Typenex Co-Investment, LLC bought and sold billions of newly-issued shares of microcap securities (i.e., penny stocks) and generated millions of dollars from those sales.
In doing so, Fife, a recidivist violator of the federal securities laws and the Entity Defendants, has violated the mandatory dealer registration requirements of the federal securities laws.
The business model of Fife and his entities has been to buy convertible promissory notes — a type of security — from penny stock issuers, convert the notes into newly-issued shares of stock, and rapidly sell those shares into the public market at a profit. From 2015 through 2019, Defendants purchased more than 250 such notes from approximately 135 different microcap issuers, demanding and receiving highly favorable terms for these notes, including terms that gave Fife and his companies deep discounts from the prevailing market price for the shares of counterparty microcap issuers.
By engaging in a regular business of buying convertible notes and then selling the resulting newly-issued shares of microcap companies’ stock into the public market, Fife and his companies operated as unregistered securities dealers and collectively generated more than $61 million in net profits.
By failing to comply with the dealer registration requirements of the Federal securities laws, the SEC claims that Keener violated Section 15(a)(1) of the Securities Exchange Act of 1934 by acting as unregistered securities dealers.
The SEC is requesting, among other things, that the Court enjoin Keener from committing further violations of the Federal securities laws as alleged in this Complaint and order them to pay disgorgement and a monetary penalty based upon these violations.
How Dilution Funders Operate
Everyone interested in penny stocks, either as an investor or an observer, knows that nearly all microcap issuers are in perpetual need of financing. Reputable banks are usually uninterested in lending, and government entities like the Small Business Association are slow to process applications. In the end, a great many small public companies turn to what are sometimes called toxic or dilution funders to meet their needs.
These funders operate by purchasing convertible promissory notes from their client companies using documents drafted by their sometimes complicit lawyers. Typically, the notes can be converted at any time into the companies’ common stock. Worse yet, when the lender converts, he receives an amount of stock fixed at a pre-negotiated discount to the market that can be as large as 70 percent. The notes often contain default and penalty provisions providing lenders with the ability to receive even more shares if the stock price drops below a certain level or upon the occurrence of certain events, such as non-compliance with SEC reporting requirements or other obligations.
As the lender sells the shares resulting from those conversions, stock price declines, often dramatically. Generally, he doesn’t convert the entire note at one time, but in several tranches. Since the conversion ratio is pegged to the security’s recent average bid price, every time he converts, he gets more stock than the time before. That is why these kinds of convertible notes are called “floorless” convertibles: there is no floor supporting a minimum bid price. Another more graphic name for them is “death spiral convertibles.”
The damage the toxic funders can do, first to the company itself, by forcing dilution that’s sometimes so catastrophic management has no choice but to do to a very large reverse split. As the dilution continues quarter over quarter, a second and then a third split may be required. Investors lose faith in the company, and everyone but the toxic lender loses money.
Toxic Lenders Don’t Act Alone
Our research also indicates that transfer agents and questionable penny stock lawyers also inhabit the toxic lending space and actively participate in and facilitate the lenders’ activities. If a transfer agent refuses to accommodate the lender by converting his notes and issuing unrestricted stock to him, he may be sued. Many of the transfer agencies that deal with OTC issuers are small businesses operating on a shoestring. They can’t afford expensive litigation, and so they often do as the toxic lenders tell them.
A handful of penny stock law firms have been involved in facilitating the sale of billions of shares of stock by the unregistered dealers, participating in both the preparation of the convertible notes and related agreements and arranging for other lawyers to provide legal opinions to facilitate the public sale of the shares. It will be interesting to see if the toxic funders eventually bring malpractice actions against the lawyers who guided them through their unlawful activity.
There are a number of red flags raised by the toxic lenders’ habitual activities. Both companies and investors should avoid involvement with:
- toxic funders who require companies to use “approved transfer agents” to ensure that their unlawful note conversion requests are honored;
- toxic funders whose financing agreements include clauses requiring the company to pay an inflated fee (as high as 10 times the normal rate) to the transfer agent for the issuance of shares to them upon conversion of notes and legend removals;
- toxic funders who appear with other toxic funders over and over in the same companies during the same time periods;
- toxic financing companies that are owned or partially owned by penny stock lawyers who also purport to represent the issuer;
- hidden transaction fees including but not limited to legal fees, penalties, inflated transfer agent fees;
- true-up provisions requiring the company to issue additional stock to the lender if the security’s price declines or is diluted.
In our practice, we have noted that some transfer agents receiving inflated fees offered in the toxic lender’s agreement self-imposed deadlines on the issuer in order to court favor with the toxic lender. In some instances, issuers have been granted only hours to engage counsel to review a lender’s request for conversion.
What the SEC Says About Dealers
The SEC offers a useful Guide to Broker-Dealer Registration designed to answer any questions individuals and entities may have about this issue. Since the brokerage’s retail investors use are called “broker-dealers,” many may believe a broker and a dealer are more or less the same things. They are not. What they have in common is that anyone who qualifies as either must register with the SEC and join a self-regulatory organization (“SRO”). In cases like the ones under discussion, the relevant SRO would be the Financial Industry Regulatory Authority (“FINRA”).
The Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Clearly, traditional stockbrokers are brokers by the SEC’s definition, as are market makers who act as middlemen in trade executions.
The difference between a broker and a dealer is that the broker acts as an agent, while a dealer acts as a principal. The Exchange Act defines a “dealer” as “any person engaged in the business of buying and selling securities… for such person’s own account through a broker or otherwise,” but specifically excludes from the definition “a person that buys or sells securities… for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” 15 U.S.C. § 78c(a)(5). According to the Guide, the latter would be considered “traders.”
The Act’s definition of “dealer” “connote[s] a certain regularity of participation in securities transactions at key points in the chain of distribution.” Mass. Fin. Servs., Inc. v. Sec. Investor Prot. Corp., 411 F. Supp. 411, 415 (D. Mass. 1976); see also SEC v. Ridenour, 913 F.2d 515, 517 (8th Cir. 1990) (finding that the defendant was a dealer because his high “level of [trading] activity . . . made him more than an active investor”). “[T]he primary indicia in determining that a person has ‘engaged in the business’ within the meaning of the term ‘dealer’ is that the level of participation in purchasing and selling securities involves more than a few isolated transactions. Furthermore, the SEC makes clear in its Guide that a business may need to register as a dealer if it “holds [itself] out as being willing to buy and sell a particular security on a continuous basis.” (SEC, Guide to Broker-Dealer Registration, Ex. V to Doc. 54, at 5).
In Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970), the Supreme Court stated that Section 29(b), which provides that contracts made or performed in violation of any provision of the Securities and Exchange Act or any rule of regulation thereunder “shall be void (1) as regards the rights of any person who, in violation of any such provision, rule, regulation, or order, shall have made or engaged in the performance of any such contract shall be void“. Further, 15 USC §78cc expressly voids such contracts raising important issues for both issuers and dilution funders.
15 U.S.C. § 78cc(b) states:
“Every contract made in violation of any provision of this chapter or of any rule or regulation thereunder, and every contract (including any contract for listing a security on an exchange) heretofore or hereafter made, the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this chapter or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract, and (2) as regards the rights of any person who, not being a party to such contract, shall have acquired any right thereunder with actual knowledge of the facts by reason of which the making or performance of such contract was in violation of any such provision, rule, or regulation: Provided, (A) That no contract shall be void by reason of this subsection because of any violation of any rule or regulation prescribed pursuant to paragraph (3) of subsection (c) of section 78o of this title, and (B) that no contract shall be deemed to be void by reason of this subsection in any action maintained in reliance upon this subsection, by any person to or for whom any broker or dealer sells, or from or for whom any broker or dealer purchases, a security in violation of any rule or regulation prescribed pursuant to paragraph (1) or (2) of subsection (c) of section 78o of this title, unless such action is brought within one year after the discovery that such sale or purchase involves such violation and within three years after such violation. The Commission may, in a rule or regulation prescribed pursuant to such paragraph (2) of such section 78o(c) of this title, designate such rule or regulation, or portion thereof, as a rule or regulation, or portion thereof, a contract in violation of which shall not be void by reason of this subsection.”
Without proper registration, the Securities Act declares the Agreement void. (15 U.S.C. §78c). If the dilution funder is not properly registered as a dealer and its performance of the financing terms is illegal, any agreement related thereto is not enforceable, and no valid consideration was paid for the issuance of the shares issued to the dilution funder. As a result, Rule 144 is not available for the dilution funder’s resale of the shares.
Individuals who think they may be acting as a dealer should ask themselves:
- Do you advertise or otherwise let others know that you are in the business of buying and selling securities?
- Do you do business with the public (either retail or institutional)?
- Do you make a market in, or quote prices for both purchases and sales of, one or more securities?
- Do you participate in a “selling group” or otherwise underwrite securities?
- Do you provide services to investors, such as handling money and securities, extending credit, or giving investment advice?
- Do you write derivatives contracts that are securities?
Registration as a Dealer
A person who seeks to register with the SEC as a dealer must file an application on a form called Form BD. It requires detailed information about the applicant entity and its principals, controlling persons, and employees. The applicant must meet the statutory requirements to engage in a business that involves high professional standards, and the toxic funding business would not adhere to this standard.
Some toxic lenders don’t register as dealers simply because it would mean more work for them and would force them to adhere to standards that might affect the amount of money they make on their deals. In addition, quite a few of them have had run-ins with the securities regulators in the past, and so their applications are unlikely to be approved, should they wish to try.
Conclusion
Toxic funders have wreaked havoc with OTC companies for decades, but they’ve proved difficult for the SEC to rein in. In the past, they insisted that they and their clients were bound only by the financing agreements they both signed: the issuers knew, or should have known, what they were getting into.
However, the SEC has begun to pursue a new theory of these kinds of cases, invoking the funders’ failure to register as dealers. The SEC defines a dealer as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” Individuals who buy and sell securities for themselves are usually considered to be “traders” and are exempted from the dealer definition. What distinguishes a dealer from a trader is that the dealer “buys and sells as part of a regular business,” while a trader does not.
The SEC seems interested in putting the toxic funders out of business by forcing them to register as dealers. Judge Cooke’s favorable ruling on the SEC’s motion for summary judgment against Almagarby and Microcap Equity is likely to lead to a similar judgment against John Fierro, Justin Keener, and John Fife. It could effectively drive the dilution funders out of the marketplace.
Despite the ongoing litigation against Fierro, Keener, and Fife, toxic funding remains prevalent in the penny stock market. Our research has shown that hundreds of penny stock Issuers are currently engaged in toxic financing, and dozens of individuals and companies are currently engaged in providing toxic funding to public Issuers. The overwhelming majority of these funders are not registered as dealers and are engaging in the same type of violations that led to a summary judgment against Almagardy and pending charges against Fierro, Keener, Fife.
It will be interesting to see what judgments against Fierro, Keener, and Fife do to curb toxic funding as it currently exists and if the SEC will keep its foot on the pedal and continue its pursuant to protect Issuers and investors against the extreme damage caused by toxic funders.
For further information about convertible note toxic lenders and unregistered dealers, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or www.securitieslawyer101.com. 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 Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855
www.SecuritiesLawyer101.com
https://www.securitieslawyer101.com/2017/ibrahim-almagarby/
https://www.securitieslawyer101.com/2020/sec-says-dilution-funder-john-fierro-is-not-a-dealer/
https://www.securitieslawyer101.com/2020/unregistered-dealers-the-scam-goes-on/
