SEC Says Unregistered Dealer Almagarby’s Convertible Notes Are Toast

On November 17, 2017, the Securities and Exchange Commission (“SEC”) filed an enforcement action against Ibrahim Almagarby and his company Microcap Equity Group LLC. Both defendants were charged with two counts: effecting transactions, or inducing or attempting to induce the purchase or sale of securities using the instrumentalities of interstate commerce while not registered with the Commission of a dealer; and, as to Almagarby only, violating the Securities and Exchange Act of 1934 (“Exchange Act”) through his control of Microcap Equity. The SEC Action was filed in the U.S. District Court for the Southern District of Florida.

At the time the SEC filed its enforcement action, Almagarby was only 27 years old. He’d formed Microcap Equity Group in Florida in January 2013 with the intention, the SEC says, of using it to buy and sell securities for the defendants’ own accounts, “as part of a regular business.” That business would be familiar to anyone who follows the OTC Marketplace: the defendants purchased convertible notes from small companies in need of cash for operations and then converted all or part of the notes into common stock and sold that stock on the open market.

To those unfamiliar with the process, it may sound innocuous enough—even helpful to small businesses with money problems—but it is not. There are two chief reasons for that. First, upon conversion, Almagarby enjoyed a large—in most cases 50 percent—discount to the current market price. Second, the conversion rate for the common stock issued was market-adjustable. That is, rather than be fixed at a specific price, it would be calculated at the time of conversion, based on a formula agreed upon with the issuer. Usually, it would be tied to the bid price of the stock for a short time preceding the conversion. 

Combined, these features practically guaranteed a hefty profit for Almagarby. They unquestionably guaranteed the kind of dilution investors dread. Worse yet, the defendants usually didn’t convert the entire note. Had they done so, they would have become ten percent owners of the issuer, causing Rule 144 to be unavailable for resale of their stock.  A standard feature of these transactions is the use of an equity blocker clause that limits the maximum amount of stock the lender may hold at any one time to 9.99 percent, or even 4.99 percent preventing the lender from being deemed an affiliate subject to Rule 144’s volume limitations. As a consequence, conversions are done on a rolling basis. As the lender sells the stock obtained in one conversion into the market, the stock price will drop. The rate for the next conversion will be based on that lower price. With each conversion, the lender will receive more stock for the dollar amount converted, increasing dilution that may by then already be unmanageable.  In these types of financings, it is not unusual for the conversions to cause the issuer’s outstanding shares to increase 100-fold eventually.

What Almagarby did is called “toxic funding,” or “death spiral financing.” It damages companies and shareholders alike. As issuers’ stock slides into the hundredths of pennies and shares outstanding soar into the billions, they may be forced to undertake reverse splits and then sell yet more convertible notes. Many eventually go out of business, leaving behind abandoned pubic shells that can be snapped up by custodianship lawyers and specialists who specialize in “cleaning up” and selling shells to owners of private businesses who want to go public.

The SEC has been concerned about toxic funding for at least 10 years and has made sporadic efforts to deal with it. It’s gone after clearing firms and transfer agents for failure to submit Suspicious Activity Reports (SARs) when they act on potentially fraudulent documents supplied to them in connection with conversions of convertible securities. While that initiative, along with attempts to discourage brokers from accepting converted penny stock for deposit, has had some success, it can only address a limited number of transactions and actors.

By the time Almagarby’s enterprise hit the SEC’s radar, it had decided to try a new tactic: to sue active toxic funders who’d dealt with large numbers of issuers and to disgorge their profits and bar them from further activity in the OTC market. Even more importantly, the SEC also seeks to void all of Almagarby’s prior and current transactions involving convertible notes and to cancel any stock he may have left to sell.

The SEC Complaint

The SEC’s complaint against Almagarby and Microcap Equity Group is short and sweet. The agency explains that between January 2013 and July 2016, the defendants purchased more than $1.1 million of convertible debt from penny stock issuers, converted it into more than 7.4 billion shares of the issuers’ stock, and sold that stock into the public market. By doing so, they made a profit of $1,474,901.63, the agency claims. 

Simply buying and selling stock for one’s own account is, of course, not a violation of the securities laws. But the SEC argues that doing so as a regular business, without registering as a dealer with the SEC and FINRA, is.

In 2008, the SEC’s Division of Trading and Markets compiled a brief Guide to Broker-Dealer Registration intended for the use of anyone who might wonder if he was a broker or dealer and so susceptible to the registration requirements of the Exchange Act. In its discussion, it first notes that “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise,” is a dealer. Since, on its face, that definition could apply to anyone with an active brokerage account, it then enlarges the discussion, making clear that:

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.

It offers a few additional specifics: a “person who holds himself out as being willing to buy and sell a particular security on a continuous basis” is a dealer. So is a person or firm that advertises or communicates with the public in other ways that he is in the business of buying and selling securities. 

The second paragraph of the SEC complaint alleges that Almagarby and Microcap Equity engaged in the buying and selling of securities as a “regular business.” The SEC furnishes a list of 39 issuers from whom Almagarby purchased convertible notes during the relevant period and asks that the judge order Microcap Equity “to surrender for cancellation its remaining shares of stock of, and surrender its remaining conversion rights under the convertible securities issued by the following issuers”:

Aluf Holdings, Inc., Axxess Pharma, Inc., Bulova Technologies Group, Inc., CD International Enterprises, Inc., CUBA Beverage Company, Daniels Corporate Advisory Company, Inc., Dewmar International BMC, Inc., East Coast Diversified Corp., Elray Resources, Inc., Energy Revenue America, Inc., Eyes on the Go, Inc., Gold & Silver Mining of Nevada, Inc., Gold and GemStone Mining Inc., Green Energy Enterprises, Inc., Greenfield Farms Food, Inc., Grid Petroleum Corp./ Simlatus Corporation, Halberd Corporation, Halitron, Inc., Healthnostics, Inc., Healthy & Tasty Brands Corporation (a/k/a GRILLiT, Inc.), Hybrid Coating Technologies, Inc., In Ovations Holdings, Inc., Indo Global Exchange(s) Pte, Ltd., InoLife Technologies, Inc., InternetArray, Inc., Las Vegas Railway Express, Inc., LIG Assets, Inc., Medical Care Technologies Inc., Mining Global, Inc., MyECheck, Inc., Next Galaxy Corp., North American Cannabis Holdings, Inc., PM&E, Inc., PotNetwork Holdings Inc., PPJ Healthcare Enterprises, Inc., Quasar Aerospace Industries, Inc., Sanomedics, Inc., Seven Arts Entertainment, Inc., and Urban Ag Corp.

Many of these companies are among the OTC market’s most notable super-diluters of the past decade. Quasar Aerospace Industries (QASP; now Green Energy Enterprise, GYOG) did a 1:1000 reverse split in 2015 and still has 2 billion shares outstanding; Elray Resources (ELRA) did five reverse splits between early 2013 and late 2015 and has 2.4 billion shares outstanding; Halitron (HAON) has done no splits, and has 14.4 billion shares outstanding.

It seems nearly all of the companies have by now been abandoned by management. Most are no longer making disclosures of any kind to investors and are categorized by OTC Markets Group as “dark or defunct.” Trading in two of the stocks, Green Energy Enterprise (GYOG) and Eyes on the Go (AXCG), was suspended by the SEC on February 26, 2021, for reasons unrelated to Almagarby’s earlier depredations. 

It would be a gross understatement to say these stocks turned out to be poor investments for shareholders who once believed they showed promise.

Almagarby, unlike many people in his line of work, didn’t buy “new” promissory notes. He instead picked up “aged debt” from earlier debt holders. That gave him an extra advantage: under Rule 144, the original holding period “tacked” onto his purchase, so he was free to convert and sell immediately. As an example, the SEC offers the story of his dealings with Halitron (HAON). On July 1, 2016, he bought debt worth $20,184.10 from a noteholder for face value. At the same time, he negotiated a deal with HAON whereby the company would allow him to convert the note to common stock immediately on favorable terms. We learn in subsequent filings HAON issued a convertible debenture to Microcap Equity; its terms included a discount to market of 50 percent and the right to immediate conversion. On July 6, Almagarby converted the debt into 25,230,125 shares of stock, which he sold between July 22 and August 8. The transaction yielded net proceeds of $56,177.52 and a net profit of $35,993.42.

The Case Continues

When sued by the SEC, Almagarby chose to fight rather than to settle. On January 16, 2018, he filed a motion to dismiss and then on January 18, a corrected motion to dismiss, seeking to show that the SEC had failed to state a claim, and moreover that its allegation that Almagarby and Microcap Equity had acted collectively as a dealer was conclusory. (For the full docket, see here.)

In his motion, Almagarby portrayed himself as just a kid trying to make a buck, “a twenty-seven-year-old, part-time college student, rather than a billion-dollar hedge fund that routinely engages in the same conduct…, [or] a Merrill Lynch, UBS, or the numerous other broker-dealers who buy and sell, or make markets in securities issued by public companies.” He was, therefore, he contends, merely a “trader” by the SEC’s definition. All he did, he says, was purchase debt from time to time, then convert and sell it. He notes further that “The SEC has simply stated, in conclusory fashion, that Defendants purchased debt and sold it as “part of a regular business” without explaining how one (1) transaction every three (3) weeks would be a part of a “regular business” for purposes of Section 3(a)(5), which defines “Dealer” and exceptions to the definition.”

The SEC responded to Almagarby’s motion by reiterating its earlier arguments and expanding on some of them,  and Almagarby countered with a memorandum supporting its own motion and disputing what he believed to be the SEC’s new claims. 

He contends, among other things, that the SEC, by alleging that Microcap Equity and its activities were intended to be a “regular business,” was imputing motives to him that he did not necessarily have. Worse yet, it added additional claims without filing an amended complaint. Those claims were:

    • Unlike a trader, Almagarby’s and MEG’s income was derived in large measure from the discount they received on the purchased securities (i.e., discount from the then prevailing market prices) and not from later appreciation in the price in those securities. (Opposition, p. 8)
    •  Due to the pricing structure of many of Almagarby’s and MEG’s DPA contracts, they were generally assured of realizing a profit on their business dealings irrespective of any subsequent declines in the price of the purchased securities. (Id.)
    •  Evidence of Almagarby’s investing business includes the fact that he (i) seemingly sought to purchase only those securities that he, with the assistance of the lawyers who drafted his various Rule 144 attorney opinion letters, deemed likely to qualify for immediate resale into the market pursuant to the Rule 144 safe harbor and (ii) frequently began selling the securities he obtained through the DPAs shortly after depositing them into MEG’s brokerage accounts. (Id.)
    •  Almagarby and MEG’s trading activities do not rely primarily on appreciation, as Traders typically do, but on active negotiation, acquisition, conversation, and sales that go well beyond that of a Trader. (Id.)

In conclusion, Almagarby maintains that the SEC has failed to allege facts showing he and Microcap Equity were “engaged in the business” of buying and selling securities.

After many months spent on discovery, complicated by some procedural delays, on October 18, 2019, the SEC, satisfied it had proved its case, filed a motion for summary judgment. Almagarby filed his own motion for summary judgment on the same day. One of the things discovery had revealed was that Microcap Equity had “contracts and informal arrangements with multiple people who would act as ‘finders’ for MEG by identifying, contacting, and referring to Almagarby issuers that had ‘aged debt’ outstanding and who were willing to ‘repay’ such debt.”

Describing himself and his work, Almagarby wrote in an email of November 2013:

My value is the fact that I can bring a sales force on the table that is already in place that has been cold calling companies and bringing deals in consistently. I manage the floor as well as structure deals and close them. I also am capable of trading. I also have many relationships with companies/shareholders that I have cultivated over the years and also have a network of deal finders. I have had a solid growth and thanks to a loyal team (including counsel, my father and his people) I am able to sail the ship smoothly.

The SEC believed that statement, among many other things, convincingly showed Almagarby was not just a “trader.” A striver, he had ambitions to scale yet greater heights:

In a November 2014 email to an associate, Almagarby wrote: “I’d love to be able to broaden the markets I am involved in and not just be involved in this tedious, highly scrutinized space filled with piker con artists working from their basements … and, later, “Trying to get into the big boys league [be]cause this space is a joke.”

The Judge Rules

In the end, Judge Marcia G. Cooke was persuaded by the SEC’s arguments. Nearly a year later, on August 17, 2020, she handed down an order on the two motions for summary judgment, granting the SEC’s and denying Almagarby’s.

In examining the instant case, Cooke let her analysis be guided by the Eleventh Circuit’s decision in SEC v. Big Apple Consulting USA, Inc., 783 F.3d 786, 809 (11th Cir. 2015). To show that Almagarby was not a “trader,” but a dealer conducting a “regular business,” she quotes a salient point from the decision:

While evidence of merely some profits from buying and selling securities may alone be inconclusive proof, the defendants’ entire business model was predicated on the purchase and sale of securities. [The defendants] depended on acquiring client stock to support operations and earn a profit… As further evidence of their dealer status, [the defendants] purchased [an issuer’s] stocks at deep discounts pursuant to its contractual agreement with [the issuer] and then sold those stocks for profit.

She also found that Almagarby was liable for Microcap Equity’s violation as its control person and rejected the defendants’ contention that “no injunction can be awarded because Defendants have voluntarily ceased the conduct at issue, and thus there is no risk of future misconduct.” 

Unsurprisingly, she points out that “absent an injunction, there is little to stop Defendants from resuming their unlawful activity.”

That said, Cooke ruled that she would determine at a later date what additional remedies are appropriate.

The Penalty Phase

Though the docket notes that the case was terminated on October 5, 2020, it isn’t yet entirely over. On October 15, the SEC filed a motion for remedies against Almagarby and Microcap Equity. In it, the SEC argues that the defendants should be enjoined from future violations of the dealer registration requirement; evidently, it, like Judge Cooke, doesn’t feel a promise never to step outside the lines again is good enough. The SEC also wants the defendants to be disgorged of the net profits from this endeavor and to pay prejudgment interest. In addition, the SEC would like to see Microcap Equity ordered to pay a modest civil penalty of $80,000, with Almagarby jointly and severally liable for Microcap Equity’s disgorgement and penalty, since he is a control person of the firm. The total financial sanctions asked by the SEC amount to $1,147,277. 

The regulator also requests penny stock bars against both defendants.

Finally, it notes that Almagarby “still owns stock and convertible notes of some of the issuers that were obtained through the violative conduct” and asks that the court order Microcap Equity to surrender the remaining shares of stock it holds for cancellation and to surrender its remaining conversion rights under any convertible notes still in its possession.

As we wrote last year in an article about toxic lender John Fierro, against whom the SEC brought a similar lawsuit, the financing agreements transacted by individuals acting as unregistered dealers are void under 15 U.S.C. § 78cc(b) and Section 29(b) of the Exchange Act.

In connection with its motion for remedies, the SEC filed a declaration by Robert W. Lowry, who worked for 22 years in the agency’s Division of Market Regulation and is now privately employed. The services he offers include providing expert witness testimony. He served as such in the Big Apple case and so is familiar with the issues raised by SEC v. Almagarby. He correctly notes that in the past 10 years, there’s been a “significant proliferation” of the kind of “microcap financing” activity conducted by the defendants in this case, and adds that “given the highly lucrative nature of the business, it is unlikely that this type of unregistered dealer activity will cease until the regulators and the courts take steps to remove the economic incentive for engaging in this type of conduct.”

While Lowry’s analysis is exhaustive and thorough in covering the damage done to the stock of the companies targeted by Almagarby and Microcap Equity, it fails to take into account one important thing: most issuers that become involved with one toxic funder will eventually work with other toxic funders, often a half dozen or more. For example, in its 10-K for fiscal year 2017, Elray Resources, one of the companies serviced by Almagarby, offers a history of the lenders it dealt with between 2013 and 2017. Microcap Equity is only one of ten. It’s likely most of the other issuers listed in the SEC’s complaint against Almagarby have similar stories. The situation is, we believe, even worse than Lowry imagines.

We expect the court will grant the SEC the remedies it seeks. But while that is positive—securities laws violators should, after all, be dealt with—it addresses only individual actors, as did the regulator’s earlier actions against clearing firms and transfer agents, and the more recent ones against other unregistered dealers. 

There may, however, be more comprehensive help on the horizon. On December 22, 2020, the Commission announced proposed changes to the Rule 144 holding periods. It would not change their length; it would instead require that a new holding period begin every time a conversion notice is presented to a company and transfer agent by a noteholder. We recently commented on the proposals at some length. If they’re adopted without alteration, they’ll create significant obstacles for lenders like Almagarby and others. New holding periods following each conversion would introduce an element of risk to their business that they’ve never had to deal with before. It would, with luck, remove a good deal of the “economic incentive” of which Lowry speaks and increase investor protections. We heartily endorse the changes proposed and hope to see them adopted.

 


For further information about this securities law blog post, 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 visit 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
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