SEC Says Dilution Funder John Fierro is a Dealer Not a Trader

Dilution Funders and Dilution Financings Challenged by SEC

We recently wrote about two interesting SEC enforcement actions that examine 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.
We recently wrote about two interesting SEC enforcement actions that examine 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.

The two SEC cases are SEC v. John D. Fierro and JDF Capital, Inc. and SEC v. Justin W. Keener, d/b/a JMJ Financial. As we explained in our first blog post on the subject, the allegations against the two men and their companies are virtually identical. Both are in the business of buying securities specifically convertible promissory notes from penny stock issuers. Their businesses were created for the purpose of facilitating the purchase of notes, the conversion of the notes to shares of stock, and the eventual resale of that stock. Because they failed to register as dealers, and so violated Section 15(a) of the Exchange Act, the SEC seeks “permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest, civil penalties, and penny stock bars.” The penny stock bars, if eventually ordered, would put both Keener and Fierro out of business.

The action against John Fierro and JDF Capital was filed on 26 February, 2020; the one against Justin Keener and JMJ Financial a month later, on March 24. Both Fierro and Keener have responded to the SEC’s complaint with motions to dismiss. Keener’s was filed less than a week ago, and so the SEC hasn’t had time to respond, but Fierro filed his motion and memorandum in support of it on May 29, a month ago. The SEC filed its opposition on June 22. 

Fierro’s Motion to Dismiss

Fierro’s motion to dismiss is predicated on his contention that the SEC has failed to state a claim for relief against either defendant. In the memorandum, he attempts to interpret the SEC’s definition of “dealer” in a way favorable to him. The SEC’s Guide to Broker-Dealer Registration, written in 2008, defines a dealer as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” The regulator does not mean to characterize ordinary retail investors who trade their own accounts as dealers, and so it invented what’s come to be called the “trader exception.” The Guide defines a trader as “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.”

Fierro’s memorandum asserts that the Commission is trying to change the playing field by expanding the registration requirements of the Exchange Act “far beyond the scope for which they were intended.” Referring to the trader exception, it goes on to claim that if the SEC’s complaint is successful, “then every day trader, hedge fund, or other market participant who purchased and sold securities for a profit would be acting as an unregistered dealer and subject to sanctions.”

But how is Fierro to be seen simply as a guy with a trading account, buying and selling securities to save up for retirement or earn vacation money? The SEC adds to the definition of a dealer “a person who holds himself out as being willing to buy and sell a particular security on a continuous basis.” That is, in fact, what the regulator alleges:  that during the relevant time, Fierro and JDF “bought convertible notes from more than 20 penny stock issuers and sold almost 6.5 billion newly issued shares of the issuers’ stock into the public market.” According to the Guide, a dealer is also someone who advertises or otherwise makes public the fact that’s he’s in the business of buying and selling securities. The SEC alleges that “Fierro operated a website for JDF that advertised its business to issuers using [its] New Jersey address. On behalf of JDF, Fierro hired independent contractors, who worked on commission, to solicit issuers who were willing to sell convertible notes to JDF. Fierro… also attended, and sometimes sponsored, conferences at which [he] solicited penny stock issuers in person…”

John Fierro’s memorandum fails to discuss all that, though it’s quick to point out that Fierro and JDF aren’t alleged to have “handled monies for third parties, made markets in any security, provided advice or lent monies.” Indeed, the SEC could, and in its own opposition to the memo, has argued some of that, but it doesn’t have to. Following a list including questions about the activities engaged in by dealers, the Guide notes: “A ‘yes’ answer to any of these questions indicates that you may need to register as a dealer.” (Emphasis ours.)

John Fierro argues further that in its complaint, the SEC is trying to “reverse existing guidance through an enforcement action.” In support, he cites the Second Circuit’s finding in Upton v. SEC: “[W]e cannot defer to the Commission’s interpretation of its rules if doing so would penalize an individual who has not received fair notice of a regulatory violation.” To demonstrate that this theory can be applied to Fierro’s case, the memo adduces a number of no-action letters issued by the SEC between the 1970s and the 1990s. No-action letters are by definition “guidance”:

An individual or entity who is not certain whether a particular product, service, or action would constitute a violation of the federal securities law may request a “no-action” letter from the SEC staff. Most no-action letters describe the request, analyze the particular facts and circumstances involved, discuss applicable laws and rules, and, if the staff grants the request for no action, concludes that the SEC staff would not recommend that the Commission take enforcement action against the requester based on the facts and representations described in the individual’s or entity’s request. The SEC staff sometimes responds in the form of an interpretive letter to requests for clarifications of certain rules and regulations.

The no-action letters cited by Fierro and attached as exhibits to his motion do address the definition of who may be a dealer, but all of them are old, and none has to do with an actor engaged in the kind of activities engaged in by Fierro. Earlier this year, the SEC’s Division of Corporation Finance posted a comprehensive index of No-Action, Interpretive and Exemptive Letters on its website. None is from earlier than January 15, 2002, but still there are thousands of them. Not a single one has to do with the provisions of Section 15(a)(1) of the Exchange Act.

Even Upton doesn’t show what Fierro says it does, according to the SEC’s opposition.  The case was an appeal following an administrative hearing. The rule in question was just a rule, not a federal statute, and the respondent had been charged with violating it based on a new interpretation not available to the public. The federal court judge agreed that the respondent had lacked the information he needed to act appropriately, and reversed the administrative law judge’s ruling.

The SEC holds that the Fierro case deals with a federal statute, not an agency rule, and that “the plain and unambiguous statutory language requiring dealers to register, including Congress’s definition of the term ‘dealer,’ have been subject to long-standing interpretation by courts and the SEC.” It goes on to cite a number of federal court cases from the past 10 years that considered the activities of unregistered dealers, in none which was the accepted definition of “dealer” successfully challenged, and concludes that John Fierro and JDF Capital had sufficient notice of the relevant laws and how they’d been interpreted by the courts.  There was, the regulator concludes, no denial of due process.

The River North Litigation

In fact, one of Fierro’s attorneys in the instant case had very good reason to be familiar with recent litigation involving unregistered dealers. On March 11, 2019, the SEC announced charges against “nine individuals and companies in a multi-million dollar stock distribution and market manipulation scheme involving two microcap companies, NanoTech Entertainment, Inc. and NanoTech Gaming, Inc.” The tale is a particularly lurid one, involving as does David Foley, the notorious former CEO of NanoTech (NTEK) and NanoTech Gaming (NTGL), who with the help of his wife Lisa and his brother Jeffrey ran the stock distribution scam from the prison where he’d been incarcerated on unrelated charges in mid-2015.

As the SEC’s complaint explains, Foley owned or controlled a considerable number of convertible promissory notes and debentures he’d failed to disclose. Before he was bundled off to prison, he and Lisa created three companies, and assigned to them his remaining notes for no consideration. He continued the scheme once he’d taken up residence in the slammer, instructing Lisa how to convert the notes and sell the shares to River North Equity LLC. River North is an Illinois company owned by Edward Liceaga, its president. Its business is to buy and sell penny stocks through the conversion of promissory notes. Another defendant in the SEC case, Michael Chavez, served as River North’s Director of Business Development.

Between February 2014 and October 2016, Foley sold 1.1 billion shares of NTEK and 19.1 billion shares of NTGL to River North in a complicated series of transactions. According to the SEC, River North paid about $12.5 million to David and Lisa Foley, and then sold the stock for more than $17 million. Liceaga profited to the tune of $3.4 million, while the Foleys did even better, raking in $4.9 million.

A final defendant, Bennie Blankenship, is a stock promoter who pumped NTEK and NTGL so the other participants in the scheme could get the biggest bang for their buck.

The story of the NTEK litigation is of interest here because one of the attorneys now representing John Fierro also represents Edward Liceaga. On May 10, 2019, he filed a motion for partial dismissal of the SEC complaint, and a memorandum in support of it. The filing is virtually identical to what he’d later file for Fierro. Not only does it introduce the same concepts, in the same order; it also makes use of the same words to describe them. That is not necessarily a problem. If a lawyer develops an ingenious defense against a charge, there’s no reason for him to employ it only once. Moreover, the motion to dismiss and its memo in support aren’t the only filings this particular lawyer will submit on Liceaga’s behalf; Liceaga has also been charged with violating Sections 5(a) and 5(c) of the Securities Act, offenses that will, according to his attorney be addressed at a later time.

What is truly remarkable, though, is that Liceaga’s motion was ruled upon by the judge in the NTEK case on December 4, 2019, more than six months before the attorney filed its twin in the Fierro case. The judge, Thomas M. Durkin, was unpersuaded by its arguments, and denied it in its entirety. (Chavez, the River North employee, hired a different attorney, who filed his own motion to dismiss. It, too, was denied.)

Judge Durkin began his opinion by noting that both motions under consideration challenge the “sufficiency of the complaint,” inasmuch as they assert the SEC has failed to state a claim. Citing the qualities that make a claim persuasive, he goes on to explain that as with all motions to dismiss, “the Court accepts all well-pleaded facts as true and draws all reasonable inferences in favor of the non-moving party.” As with Fierro, the charges Liceaga defended against in his motion are acting, with River North, as an unlicensed dealer, and aiding and abetting River North’s violations.

Durkin embarked on his analysis with a discussion of the broker and dealer registration requirements of Section 15(a) of the Exchange Act. Recognizing that the definition of what constitutes a “dealer” “has not been subject to extensive judicial interpretation, he observes that the SEC alleges River North bought and sold more than 10 billion shares of stock from more than 62 microcap issuers and quickly resold them, realizing approximately $31 million in profit. He concludes that “it is more than plausible that River North meets the statutory ‘dealer’ definition.”

As Fierro and JDF Capital have more recently done, Liceaga, through the same counsel, produced a “laundry list of factors set forth in various SEC no-action letters and other guidance.” River North complained the SEC didn’t include a number of elements critical to the definition of a dealer: whether River North extended credit, acted as an underwriter, held itself out publicly as willing to buy or sell securities on a continuing basis, or carried a dealer inventory. The judge pointed out in oral argument that “these factors… are not controlling. They are neither exclusive, nor function as a checklist through which a court must march to resolve a dispositive motion.”

In addition, Durkin was persuaded that the SEC “sufficiently alleged” that River North extended credit to the Foleys, and felt it was clear that the company advertised its willingness to buy securities at its website. He was also convinced the SEC sufficiently alleged River North was a dealer because it purchased stock at a discount price directly from its issuers, rather than in the open market, and because it was able to turn a profit even when the stock price didn’t increase, thanks to its markup.

The judge dealt quickly with Liceaga’s claims that he was not an aider and abettor because the SEC did not plausibly allege scienter, and rejected his objection that his right to due process had been violated.

Judge Durkin took pains to note that similar cases he’d reviewed were not disposed until much later in the judicial process, and closed with this conclusion:

The Court’s ruling provides no comment on the ultimate success of the SEC’s allegations. But because each of the SEC’s claims is plausible as alleged, that issue is for another day. The motions to dismiss are denied.

Now Judge Michael A. Shipp, who’s assigned to the Fierro case, will have to rule on the same question: did the SEC make a sufficient and plausible complaint? Before he writes his own opinion, he’ll surely know how his counterpart in Chicago dealt with a motion to dismiss almost identical to Fierro’s. Meanwhile, in Florida, where the Justin Keener action will be adjudicated, the SEC will be submitting its own objection to the motion to dismiss in that case.

All three cases are worth following. It seems likely that if the SEC succeeds in establishing a tried-in-court standard for its definition of an unregistered dealer, staying in business may soon become more difficult for dilution funders. Additionally, we expect to see more private litigation against dilution funders as well as market participants and professional gatekeepers enabling unregistered dealer activities.

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