SEC Amends Rule 144 for Convertible Notes and Unregistered Dealers


On December 22, 2020, the Securities and Exchange Commission (“SEC”)  voted to propose amendments to Rule 144 to eliminate tacking for shares acquired upon exercise or conversion of market-adjustable securities. We have previously discussed the pattern of unregistered dealer activity associated with toxic convertible notes sold to issuers on the OTC Markets. Market adjustable securities are most often promissory notes, warrants, or preferred stock convertible into common or other shares at a dramatic discount to the issuer’s trading price. These types of market adjustable securities are known as “toxic financings” or “death spirals” for a reason. These financings are typically provided by persons acting as unregistered dealers, and they have crippling effects on small businesses and investors.

The SEC’s proposal is consistent with its recent enforcement actions targeting unregistered dealers involved in the business of toxic convertible note lending.

The proposed amendment the treatment of convertible notes under Rule 144 would not apply to securities issued by listed companies, the theory being that exchange listing standards requiring shareholder approval for substantial issuances would largely prevent these dilutive issuances.

What is a Market-Adjustable Security?

Market-adjustable securities  are most often convertible notes with conversion rates that are not fixed and adjust for and protect the toxic financier against general decreases in the market value of the underlying securities. Because their floating conversion rates can result in substantial dilution to existing shareholders and investors, these securities are often referred to as “death-spiral” or “toxic” conversions. The SEC provides a useful example in its proposal. A Market-Adjust Security would include a convertible security with a conversion rate that may be discounted from a weighted average price of the publicly traded securities, typically, common stock, calculated for a period leading up to the date of conversion or exchange. Therefore, the conversion price provides a discount from the recent market price that can be realized at the time sales of the underlying securities begin. This provides the toxic financier the opportunity to sell on a continuous basis and receive more shares of the issuer as the stock price declines. The lower the price, the more shares the financier receives.

Who are the Unregistered Dealers Acquiring Market Adjustable Securities?

SEC cases on the issue of unregistered dealer activity span more than a decade, and the analysis is not complicated.  An unregistered dealer is a person or entity who engages in the purchase and sale of securities on a regular basis. Case law tells us that a regular basis is more than one or a few transactions. In fact, the analysis is so simple that the SEC has consistently won numerous summary judgment motions in enforcement actions on the issue of what constitutes unregistered dealer activity, and they will win many more. Unregistered dealers almost always rely on Rule 144 for the resale of their shares.

Anatomy of an Equity Blocker in Toxic Financings

On the OTC Markets, toxic financings take the form of a convertible note or preferred stock convertible at an adjustable discount to the issuer’s trading price. The instruments provide the toxic financiers with the ability to receive large amounts of shares upon conversion or exercise. Sometimes these amounts received are so large that the issuer’s outstanding shares double or triple. T

The instruments contain equity blocker clauses that provide the toxic financiers cannot receive more than 9.99% of the issuer’s outstanding shares to avoid affiliate status. This results in multiple conversions of the note or preferred shares. Under the SEC’s proposal, each conversion will require a new holding period instead of allowing the holder to receive unrestricted shares upon conversion. This holding period will be either 6 months for a reporting issuer or 12 months for a non-reporter issuer assuming the issuer has never been a shell company.

How The SEC Proposals Target Toxic Financings With Market-Adjustable Securities 

The SEC proposal will effectively stop some unregistered dealers providing convertible note financings in their tracks, and they will move on to other schemes or retire with the profits from their unregistered dealer activity.  Others will purport to use other exemptions for their resales using the same complicit lawyers they used for their toxic financings to render baseless opinions stating that Section 3(a)(9) and Section 3(a)(10) of the Securities Act are available for their resales.

Rule 144 provides a non-exclusive safe harbor from the statutory definition of “underwriter” to help sellers assess whether the Securities Act Section 4(a)(1) exemption—the exemption for “transactions by any person other than an issuer, underwriter, or dealer”—is available for their resales of restricted or control securities. Rule 144’s safe harbor enables a seller of securities to establish that they did not purchase the securities with a view to distribution and, therefore, is not an underwriter.

The SEC has stated that if a seller assumes the full economic risks of investment for an appropriate holding period prior to resale, it can help to establish “that the seller did not purchase the securities with a view to distribution,” i.e., “is not acting as a conduit, directly or indirectly, on behalf of the issuer for the sale of unregistered securities to the public.” 

Notably, the SEC has also stated that the application of the “tacking” provisions of Rule 144 to convertible notes and other market-adjustable securities undermines Rule 144’s holding period.

Rule 144(d)(3)(ii) provides, “If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms.”  

Under the SEC proposals, the holding period for “market-adjustable securities” would not start until the underlying securities are acquired upon conversion or exchange of the convertible note, preferred shares, or other exchangeable security, significantly impairing the unregistered dealer’s ability to sell into the market on a continuous basis.

In practice, market-adjustable securities have a discounted conversion or exchange feature that typically provides toxic financiers with protection against investment losses that would occur due to declines in the market value of the underlying securities prior to conversion or exchange. As a result, these toxic financiers are not exposed to the market risk associated with holding the underlying security prior to conversion or exchange; they are only exposed to that market risk during the time that they hold the underlying security after the conversion or exchange.  The SEC has stated that if the unregistered dealer converts and promptly resells the underlying security, the holder has not really assumed the economic risks of investment of the underlying security.


Amendment to the Form 144 Filing Requirements 

The SEC proposes to amend Rules 101(a) and 101(b) of Reg S-T to require the electronic filing of all Form 144 filings relating to securities of SEC reporting companies. The proposals would also eliminate Form 144 reporting altogether for securities of non-reporting companies.  The SEC proposals include developing an online fillable Form 144 and a Form 4 to report the same sale of equity securities if desired. The proposals also provide for an option on EDGAR to file a Form 144 and a Form 4 through a single user interface, using the information entered into the fields to create separate Form 4 and Form 144 filings. The SEC is proposing to amend the Form 144 filing deadline to coincide with the Form 4 filing deadline. 

Rule 10b5-1(c) Transaction Indication in Forms 4 and 5.

Form 144 requires the seller to represent that he or she does not know of any material adverse information regarding the current and prospective operations of the issuer that has not been publicly disclosed as of the time of signing.  Issuers who have adopted Rule 10b5-1(c) written trading plans or instructions may make the representation as of the date they adopted the plan or gave instructions, rather than the date they signed the Form 144. The SEC proposals would permit filers of Form 4 and 5 to indicate through a check box on the Form that the reported sale or purchase was made pursuant to Rule 10b5- 1(c). 

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  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