Is My Dilution Funder a Dealer? – SEC Toxic Financing Actions

On March 4, 2020, the SEC issued an order providing conditional regulatory relief and assistance to reporting companies impacted by 2019 novel coronavirus disease (COVID-19). On March 25, 2020, the SEC extended an earlier March 4, order providing companies an additional 45 days to comply with their SEC reporting requirements under the Securities Exchange Act  of 1934, as amended (the “Exchange Act”) for filings and reports with deadlines between March 1, 2020 and July 1, 2020, if:
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. In these  dilution financings, the lenders’ terms contain special features that almost always result in harm to investors, and to the company itself. 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 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.”

Some penny stock CEOs fail to realize what they’re getting into when they sign a financing agreement of this kind; others are so desperate for funds to keep their doors open they don’t care. But the effect on investors and companies is almost always negative. The issuer’s stock price may drop into the hundredths of pennies; worse yet, management may be forced to execute a reverse split, which will invariably be followed by yet more toxic dilution. Obviously, none of this is good for investors, the company, or the over-the-counter equity market in the broader sense. But how can toxic financing be stopped, or at least hindered?

The Securities and Exchange Commission (“SEC”) has recently made life more difficult for the toxic funders. In recent months, it’s brought enforcement actions seeking to show that financiers offering to buy convertible promissory notes were acting as unregistered dealers, in violation of the Securities Exchange Act of 1934  the (“Exchange Act”).  In this blog post, we examine two of the lawsuits, and their possible consequences in detail.

What the SEC Says About Dealers

In the first SEC Action, filed against  John D. Fierro and his company JDF Capital, Inc. Fierro (not to be confused with John Fiero the notorious short seller of the 1990s) for violations of the Exchange Act’s registration requirements for dealers, and also as a control person for JDF’s violations. Another similar  suit charges Justin W. Keener, d/b/a JMJ Financial, with violation of the provisions of Section 15(a)(1) of the Exchange Act.

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 brokerages retail investors use are called “broker-dealers,” many may believe a broker and a dealer are more or less the same thing. 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. Ridenour913 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

Registration requires a dealer to provide detailed information to FINRA and the SEC. Among other things, this information includes the identity of its direct and indirect owners and executive officers, and of those who control the business. The applicant must also disclose certain background information including past criminal or regulatory actions and bankruptcies. Registered dealers are subject to filing requirements and oversight by FINRA. Registered dealers must also adopt and adhere to certain compliance procedures and submit disclosures about key personnel and representatives and prior securities law violations.

SEC v. Fierro and JDF Capital, Inc.

John Fierro appears to be a typical toxic lender, though perhaps he’s not been as successful as some of his peers. He owns a company, JDF Capital, that he named after himself. His and JDF’s business is to buy convertible promissory notes from penny stock companies in need of money, and then to sell them into the market once applicable holding periods have expired. Since Fierro deals mostly with companies that are SEC registrants, that period was usually six months.

His brother-in-law, Mark Allen Lefkowitz, helped out with JDF, though he isn’t charged in the SEC’s complaint. He’s described as a “Federal securities laws recidivist,” and he does indeed seem to have been up to a fair amount of no good over the years. He was once a registered representative, and according to BrokerCheck, back in the 1990s he was fined more than once for unauthorized trading in clients’ accounts. In 2004, FINRA (then the NASD) showed him the door. In 2008, the SEC charged Lefkowitz, his company Compass Capital Group, and several other individuals of conducting an unregistered public offering in the securities of 21st Century Technologies, Inc. (TFCY). For that, he received a penny stock bar. He ignored the bar, and in 2013 was indicted, along with Mark Anthony Lopez, CEO of Unico Inc. (UNCO), in connection with a $28 million fraud in which the pair dumped billions of shares of UNCO’s stock using Section 3(a)(10) of the Securities Act and custodianship shells. Lefkowitz was sentenced to 10 months in prison. He was also sued by the SEC in the matter, settled, and received another penny stock bar. Two other well-known penny stock financiers, Shane Traveller and Steven Peacock, were caught up in the case; Traveller had also been involved in the 21st Century scam as well. TFCY and UNCO stopped filing their required periodic reports with the SEC, and as a result, their registration was revoked.

Despite Lefkowitz’s past, Fierro will be carrying the bag alone in the instant case. The complaint alleges that between January 2015 and November 2017, he and JDF regularly bought promissory notes from penny stock companies, converted the notes once the holding period had elapsed, and sold the resulting shares—billions of them, according to the SEC—into the public market. More than 50 notes from 20 microcap issuers were converted during the relevant period. Fiero made, the SEC says, more than $2.3 million in profits. Those profits were made possible by the favorable terms he was able to negotiate with issuers willing to offer conversion ratios at a very generous discount to market price.

That was the business of Fierro and JDF, and they engaged in it continuously, meeting the Exchange Act’s first standard for a dealer: “a person who holds himself out as being willing to buy and sell a particularly security on a continuous basis.” Fierro created a website at which he explained to interested issuers that he was willing to purchase notes, and advertised his business along with its address in New Jersey. He also hired contractors who contacted issuers who might be willing to sell him notes, and sometimes attended or sponsored conferences at which he made his pitch to penny stock CEOs in person.

The object of the exercise was, of course, to sell the stock obtained by conversion into the market. The SEC observes that “[s]elling large quantities of newly issued shares into the market is a common attribute of a securities dealer.”

Returning to the question of those hefty discounts, it’s explained in the complaint that the discounts “generally ranged between 35 and 50 percent less than the lowest closing price for the stock during the 10 to 25 trading days preceding the conversion request… The vast majority of Defendants’ profits resulted from the discounted prices at which they acquired shares from the issuers to sell into the market. This mechanism, which gave Defendants a spread (or markup) on the stock that they sold, is a common attribute of a securities dealer.”

Examples of the stocks that provided Fierro’s profits are offered. They are 5BARz International, Inc. (BARZ; registration revoked in August 2019), Sparta Commercial Services (SRCO, now a delinquent filer), and Solar Wind Energy Tower, Inc (SWET; registration revoked in October 2019). Charts for the times during which Fierro was selling show steep declines in stock price. GTEH, the only one of the four that’s still trading actively, did a 1:7,000 reverse split at the end of 2018, and is already back in the triple zeros most days.

The SEC closes its complaint by reiterating that registering as a dealer provides important information about the dealer’s business, “including but not limited to the names of the direct and indirect owners and executive officers of the business, certain arrangements with other persons or entities, the identities of those who control the business, the states in which the dealer does business, past criminal or regulatory actions of the dealer or any affiliate that controls the business, and financial information, including bankruptcy history.” Had Fierro registered as a dealer, he’d have been obliged to disclose the role played by his brother-in-law Lefkowitz, who had, in addition to the practical help he offered, loaned JDF $500,000. The SEC would no doubt have barred Fierro and JDF from associating with Lefkowitz, who himself had been barred from associating with a broker dealer years earlier. 

SEC v. Keener d/b/a JMJ Financial

The SEC’s suit against Keener is, as noted above, closely similar to its suit against Fierro and JDF. In 2011, Keener became part owner of Gordon & Company, a FINRA member the regulator described as a small, unprofitable member firm with a niche business, primarily writing and repurchasing put and call options. In April of that year, Keener and an outfit called the Cobblestone Trust became Class B limited partners in Gordon. The trustee of Cobblestone was Pauline Fife, wife of John Fife, who’d recently been barred by the SEC from acting as an investment adviser.

As soon as Keener and Cobblestone bought into Cobblestone, Keener’s account statement began showing sales of millions of shares of sub-penny stocks. FINRA was suspicious, and at the end of September 2011, sent Gordon a letter explaining that upon review of the limited partnership agreement, staff had “determined that Gordon must file Continuing Membership Application reflecting the ownership and control interests of Keener and Cobblestone; register Keener and John Fife as principals; and file an application for Fife to be associated with the firm despite being statutorily disqualified.” It seems FINRA has a sense of humor.

In October, evidently having done some digging of its own, Gordon told FINRA it would no longer be trading for Keener and Fife, and closed Keener’s account without his consent. In December, it redeemed the two men’s partnership interests. Keener had a trading account at another brokerage, one FINRA refers to as “Firm W.” Evidently staff investigators didn’t like what they saw, and opened an investigation that had not been completed by mid-2012. FINRA explained that:

The sole focus of the investigation of Firm W is Keener’s trading, which was the bulk of Firm W’s activity during the time period relevant to the investigation. The investigators are looking at the circumstances of the delivery and liquidation of a significant quantity of stock certificates for Keener’s account, with the proceeds wired to Keener almost immediately upon liquidation. FINRA’s investigators are concerned that the trading might have been unregistered distributions of securities in violation of Section 5 of the Securities Act of 1933.

FINRA then served document requests on Keener and JMJ Financial, in whose name the account with Firm W had been opened. Up to that point, Keener had cooperated warily with the regulator, but he then stopped, saying through his attorney that he didn’t accept FINRA’s jurisdiction. FINRA insisted it had jurisdiction by virtue of Keener’s short-lived partial ownership of Gordon, and also argued that he “was an associated person for all purposes because he was engaged in Gordon’s securities business, and controlled Gordon as a result of his rights under the limited partnership agreement and the importance to Gordon of the revenue generated by his trading activity.”

Keener refused to comply with any of FINRA’s requests, and simply didn’t show up for his hearing. FINRA suspended him from associating with any FINRA member in any capacity, noting that the suspension would be automatically converted to a bar should he not agree to testify on-the-record.  It fined him $4,231.90, and charged him $750 for the cost of preparing the hearing transcript, which seems a bit stiff.

Keener clearly had no intention of giving up his profitable penny stock trading. In its recent complaint, the SEC defines the “relevant period” as January 2015 through January 2018, and alleges that during that time, he purchased more than 100 convertible notes from more than 100 issuers, and then dumped the stock issued when he converted the notes. Those activities generated more than $21.5 million in profit. As in the case of Fierro, the SEC notes that the greater part of that profit “came from the spread between Keener’s discounted acquisition cost for the stock and the prevailing market price,” as it would for a dealer.

Again like Fierro, he operated a website advertising his business. The site is still up and running. Keener isn’t hiding; he offers a real address in Puerto Rico, where he now lives, and proudly displays a big photo of himself on the “Who We Are” page. An interested issuer can fill out a simple form to receive “instant prequalification,” though it appears not everyone will be a lucky winner. Sad to say, the news touted at the site is stale; the most recent press releases—another way he advertises his services—are from early 2018.

He also sponsors and attends conferences at which he and his employees solicit penny stock CEOs in person. According to the SEC, he sometimes gives PowerPoint presentations in which he shows a “notarized affidavit from his accountant stating that he had $20 million ‘committed’ to purchase convertible notes from issuers.”

The companies from which Keener bought notes during the relevant period that are used as examples by the SEC are Lithium Exploration Group, Inc. (LEXG), ERHC Energy, Inc. (ERHE), and Accelera Innovations, Inc. (ACNV). They’ve done no better than the issuers Fierro “invested” in. ACNV and ERHE are extremely illiquid, and LEXG’s registration was revoked late last year. Some will remember that LEXG was one of the biggest and most successful pump and dump operations of 2011. It’s unlikely Keener was involved at that time; its stock was very closely held. Coincidentally or not, on January 29, 2018, LEXG sold a convertible promissory note to John Fierro.

The SEC lodged only one claim against Justin Keener: violation of section 15(a)(1) of the Exchange Act. No form of securities fraud was alleged. For both Keener and Fierro, the SEC asks that the court that they be enjoined from acting as unregistered dealers, and further requests a penny stock bar. The agency also requests “an appropriate civil penalty,” and disgorgement for each.

It seems probable that if the SEC wins its cases, it’ll aim high when it calculates the fines and disgorgement it feels Fierro and Keener deserve to pay. To avoid pain and pointless expense, the defendants may decide to try to negotiate a settlement; depending on what the SEC asks, one or both may consider coming to an agreement and paying up is just the cost of doing business. But what about that penny stock bar? They’ve been sued by the SEC, and the SEC is likely to prevail, so there’s no chance FINRA would allow them to register as dealers. The penny stock bar, if applied, as seems nearly certain, should prevent them from resuming their former activities. Unless, of course, either or both decides to use a relative, as John Fife did when he made his wife trustee of the Cobblestone Trust.

The real question raised by these two enforcement actions is when the SEC will bring the same charges against dozens of toxic funders out there destroying small businesses that are publicly traded. We’ll be watching to see when it does.

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 and compliance 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. For more information about going public with Form S-1, Form F-1 and Regulation A Securities Offerings, Rule 506 and Regulation CF crowdfunding,  sponsoring market makers and Form 211,  dual listings and foreign issuer listings and public company SEC reporting requirements, please contact Hamilton & Associates Law Group.

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