The Evolving SEC Actions Against Toxic Lenders

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Convertible Financing

For decades, microcap issuers on the OTC Markets in need of financing have largely been forced to turn to what are known as “toxic funders” or “toxic lenders.” The money they offer comes with a hefty price tag. It’s paid in exchange for convertible securities that are almost invariably market-adjustable. That means the toxic funder will purchase from the issuer a specific number of instruments—promissory notes, warrants, or preferred stock—that will, after the shares have been registered with the SEC or the holding period required by Rule 144 has expired, be converted into common stock and sold into the market. Theoretically, holding the shares creates risk for the funder because the price of the issuer’s common shares could decline dramatically while the funder waits to sell. 

But in reality, the lender runs almost no risk because the conversion price of the lender’s securities isn’t at a fixed price from the outset. Instead, it’s market adjustable, which means it will be determined based on the stock’s price (often its bid price) a few days before the conversion is to take place. Usually, the toxic lender will convert and sell in tranches on an ongoing basis. That is done for two principal reasons: (1) to increase the toxic lender’s profit and (2) to make it possible for the lender to avoid being considered an affiliate or control person.

The toxic lender accomplishes the latter through an “equity blocker” clause in its contract with the issuer. They limit the amount of common stock—but not convertible securities—the toxic lender may own at any one time to no more than 9.99 percent (or sometimes 4.99 percent) of the issuer’s shares outstanding shares. So, the toxic lender is free to convert and sell successive tranches on an ongoing basis within a short period of time, if he wishes. 

The toxic funder’s sales will be dilutive and will likely drive down the stock price. If that happens, thanks to the market adjustable feature of the convertibles, the toxic funder will receive stock at a lower price and even more stock the next time the toxic funder converts, and even more thereafter.

If more than one toxic funder is involved, the dilution may become catastrophic within a fairly short time. Those additional toxic funders may have anti-dilution clauses in their own contracts, which will worsen the situation for the issuer. Eventually, the company may be forced to consider a stock reverse split.

Amended Rule 15c2-11

For decades, the issuers that suffered at the hands of the “death spiral” financiers traded almost exclusively on the OTC Markets. That is beginning to change, thanks to actions taken by the Securities and Exchange Commission (“SEC”) in recent years. 

Aware of the increasing amount of fraud in the OTC Markets, the SEC first moved against high-profile paid stock promoters and investor relations providers. A series of investigations followed by litigation and some indictments began around 2012 and has continued. Results are mixed. While we deplored the depredations of promoters working with company insiders and affiliates, the current amateur and semi-pro touts working on social media are no better. 

Next, the regulator began to take an interest in the activities of toxic funders, charging Big Apple Consulting with acting as an unregistered broker-dealer. Big Apple and its subsidiary MJMM Investments acquired over 700 million shares of unregistered stock from its client CyberKey Solutions at a 50 percent discount to what was then the market price and sold it into the market. Additionally, Big Apple had acquired shares of hundreds of penny stock issuers prior to the SEC enforcement action.

Prevailing on the unregistered dealer issue on a Summary Judgment motion, the SEC had discovered a good way to deal with individuals whose chief business was to finance companies in need of capital by purchasing convertible securities from them. In the mid-to-late 2010s, Ibrahim Almagarby, John Fierro, Justin Keener, John Fife, Joseph Lerman, Alexander Dillon, Louis Posner, and more were litigated by the agency. (The Fife case has not yet been decided.) 

The SEC had also become concerned about the large number of shell companies floating about the OTC and decided to do something about it. A great many companies left for dead, often due to damage done to the share structure and price caused by the toxic funders, continued to be traded as “zombie tickers,” that is an issuer with no management or active business. These zombie tickers were ripe for fraud through social media pumping and other forms of stock manipulation.

They were also easy targets for shell vendors who sought out dormant public companies, usually incorporated in Nevada, Delaware or Florida, and brought custodianship or receivership actions in a state or local court, claiming that they’d been abandoned. If no one objected, they’d be granted control. The company would effectively become theirs, and they’d usually seek to sell it as a reverse merger candidate to a private company seeking to become publicly traded or more windfall for himself.

Some were delinquent filers that could easily be subjected to an administrative action for revocation of registration. Once those actions became final, the stock’s ticker would be removed, and any remaining shareholders would own stock in a private, though usually defunct, company.

Abandoned shells that had never registered a class of stock, or had voluntarily terminated their filing obligations, were more difficult to deal with. And so, the SEC devised a series of amendments to Rule 15c2-11 in large part designed to eliminate those shells or to make sure they couldn’t trade for long without providing “current information” to investors and the public.

A concept release and proposed rule appeared on September 25, 2019. A year later, on September 16, 2020, the final rule was published. And a year after that, on September 28, 2021, compliance with the amended rule 15c2-11 was required. 

As everyone who follows the OTC Markets knows, the amendments were extremely controversial and unpopular with everyone from investors who claimed they had the right to invest in almost completely dark companies to shell vendors to OTC Markets Group. Although the comment period for the proposed rule ended on December 30, 2019, new comments were added until a few days before the September 28, 2021 compliance date.

When the fateful day arrived, it was as bad as penny fans had feared. The securities of more than 3,000 noncompliant issuers were unceremoniously dumped to the  OTCMarkets’ “Expert Market,” also known as the Grey Market. 

Since then, a few issuers have pulled up their socks, filed registration statements, or found a market maker willing to file a Form 211 for them with FINRA so they can go public. They’ve moved back to the OTC Markets Pinks or the OTCQB. But most cannot be quoted publicly. And for reasons that have gone unexplained, U.S. brokers are unwilling to allow their clients to buy stock in them, though they’re free to sell old positions.

While there were still thousands of issuers trading OTC Markets, the thrill was gone. It can’t be said the SEC’s actions had ushered in a new era of a clean and efficient penny stock market, but volumes had dropped, and many players who’d considered themselves day traders looked for greener fields.

The Action Moves to the Exchanges

Market participants struggled to deal with the new realities created by the SEC’s rulemaking and enforcement actions. The toxic funders were naturally reluctant to give up what had been a lucrative business, but the SEC was picking them off one by one. Moreover, OTC Markets investors had finally realized their losses over the years were due to the activities of financiers buying convertible debt, not to the mostly mythical short sellers they’d blamed for decades. 

The hysteria over Shorty had, to a considerable extent, given cover to the toxic lenders. That seemed finally to have given way to a saner view of the way the markets worked when a whole new cast of characters entered the picture as supporters of the “meme stocks,” so-called because they were promoted on social media with the help of memes, many of them extremely lame. 

These stocks, chief among them GameStop Corporation (GME) and AMC Entertainment Holdings (AMC), were exchange-listed companies—traded on the New York Stock Exchange—that had run into serious difficulties. GME had brick-and-mortar stores and rented video games in an age of downloadable apps and live streaming; AMC had movie theaters whose business had been severely affected by the COVID pandemic. 

But the pandemic was not all bad: it kept many people at home, and government relief even contributed a little extra money to play with. Some used that time and money to post videos on TikTok; others took an interest in the stock market. The latter flocked to a subreddit called WallStreetBets. They were, for the most part, completely new to the markets and made no effort to seek out reliable sources. Instead, they made it up as they went along, inventing a new vocabulary in which they were APES (from the movie Return to the Planet of the Apes) who HODL’d (“held on for dear life”) and made YOLO (“you only live once”) plays. Not the stuff of Warren Buffett

They also breathed new life into Shorty as the nemesis of the retail trader and worked together to squeeze him. Their tactics were highly effective. They were aided by newly popular broker Robinhood, which—in the words of the SEC—appealed to inexperienced investors by “gamifying” the trading experience. They also charged no commissions and allowed anyone to open a margin account and trade options. Those policies added to the volatility around GME and the other meme stocks. GME was shorted, and there was a short squeeze. The stock reached a historic high of $483 in January 2021. It is currently trading at around $14. 

Many of the APES believed hedge funds were shorting “naked”: that is, shorting without borrowing shares to deliver. The SEC concluded in a report it published at the end of 2021 that “based on the staff’s review of the available data, GME did not experience persistent fails to deliver at the individual clearing member level. Specifically, staff observed that most clearing members were able to clear any fails relatively quickly, i.e., within a few days, and for the most part, did not experience fails across multiple days.”

GME’s day in the sun is over, but since then, the tactics employed by the APES have been applied to many other stocks, all of them exchange-listed. Those stocks have enjoyed high volume at times. Inexperienced APES invariably account for that by their own prescience when the stock goes up and by the nefarious actions of Shorty when it goes down. Often, however, the latter is attributable to the activity of toxic funders. Just as in the OTC Market, when lenders convert their notes and sell the resulting common stock, the stock price declines, sometimes precipitously. 

For example, John M. Fife, the lender charged by the SEC in 2020 of acting as an unregistered dealer in connection with transactions involving OTC issuers, has also purchased convertible promissory notes issued by NASDAQ companies. One is Jaguar Health, Inc. (JAGX).  In 2016, JAGX’s wholly owned subsidiary, Napo Pharmacy, issued two notes to Kingdon Associates, Kingdon Family Partnership, L.P., and M. Kingdon Offshore Master Fund, L.P. In 2017, a third note was issued to Kingdon Associates. In 2019, Fife’s Chicago Venture Partners purchased the Kingdon notes. He then entered into an agreement with Jaguar:

Subject to the terms of this Agreement, Holder and the Companies desire to exchange (such exchange is referred to as the “Note Exchange”) the Kingdon Notes for two (2) new Secured Promissory Notes; (i) one in the original principal amount of $10,535,900.42 substantially in the form attached hereto as Exhibit A (“Exchange Note 1”), and (ii) one in the original principal amount of $2,296,926.16 substantially in the form attached hereto as Exhibit B (“Exchange Note 2,” and together with Exchange Note 1, the “Exchange Notes”). The Note Exchange will consist of Holder surrendering the Kingdon Notes in return for the Exchange Notes. Other than the surrender of the Kingdon Notes, no consideration of any kind whatsoever shall be given by Holder to the Companies in connection with this Agreement.

Fife’s Chicago Venture Partners also specializes in PIPE (“Private Investment in Public Equity”) transactions. PIPEs are similar to common or garden-variety toxic financing, but somewhat more respectable. They’re used by OTC Markets and exchange-listed issuers alike. In a traditional PIPE transaction, the company issues restricted stock to the investor, who must be an institution or an accredited investor, at a discount to the market price. Usually, the issuer promises to file a registration statement for the stock so its investors will be able to sell without difficulty. 

A structured PIPE transaction is more like what OTC players are used to: the company issues convertible debt to the investor(s) rather than restricted stock and offers advantageous conversion terms. Obviously, both types of PIPEs are dilutive to ordinary shareholders.

The SEC’s Proposed Amendments to Rule 144

In December 2020, the SEC proposed changes to Rule 144 that would make conducting business a great deal more difficult and less remunerative for the toxic funders. In its press release about the changes, the SEC said specifically that its action was “designed to reduce [the] risk of unregistered distributions.” 

 Jay Clayton, then the SEC Chair, said, “Today’s proposed amendments modernize, clarify and strengthen Rule 144, including to ensure that holders of market-adjustable securities are assuming the economic risks of their investment rather than acting as a conduit for an unregistered sale of securities to the public on behalf of an issuer.” 

The proposed amendments would make another important alteration to the rule. Until that time, securities issued pursuant to Rule 144 were subject to a holding period of six months if the issuer was an SEC filer, and one year if it was not. In the case of market-adjustable securities, the holder could obtain a legal opinion and then convert all or part of those securities to the common stock of the issuer and sell them on the open market. As explained above, typically, the lender will convert and sell in several tranches. 

The new rule would make a significant difference. If it is adopted, the holding period would not begin until conversion or exchange. That is, the holding period would not start at the time of purchase of the instrument but at the time of conversion into shares. 

If a toxic lender chose to convert a tranche consisting of only one-third of his original position, he would then have to wait six months or one year before selling. The same would happen with subsequent conversions. The Rule 144 amendments would also eliminate “tacking,” which, as the SEC says, permits the “holding period of the underlying securities to be “tacked” onto the holding period of the convertible or exchangeable security [and] allows the initial holders of market-adjustable securities to structure transactions without significant economic risk prior to conversion.” That, too, encourages unregistered distributions. Under the proposed new rule, the holding period would begin again whenever the market-adjustable securities changed hands.

Shortly after the amended Rule 144 was proposed, we wrote an extensive comment letter to the Commission. As our letter indicates, we strongly favored the adoption of the proposal, although a great many commenters did not. 

Nearly three years later, the proposal has still not been adopted. It is, however, still posted as an active project on the agency’s unified agenda. It’s even near the top of the list; perhaps there’ll be some action in the new year, as a reference to the spring of 2024 may suggest.

The Proposed Rule and Exchange-Listed Issuers

Perhaps the SEC will open a new comment period somewhere along the way. We have additional suggestions to make.

Originally, the Commission specified that:

The proposed amendment would be limited to unlisted issuers because national securities exchanges registered pursuant to Section 6 of the Exchange Act have certain listing requirements, such as requiring shareholder approval of an issuance of 20 percent or more of a company’s common stock. Because market-adjustable securities have the potential to result in highly dilutive issuances of large amounts of the issuer’s securities, these required approvals are not likely to be granted in the situations the amendment is intended to address.

We have also observed that issuers that are able to satisfy the listing criteria of these exchanges have generally not been engaging in these transactions…

As we’ve pointed out, that is changing. With the OTC market reeling from the changes wrought by the amended Rule 15c2-11, investors are turning to the exchanges, particularly the NASDAQ Capital Market, in search of suitable but inexpensive plays with similar volatility to what they saw with the meme stocks. Many of the companies of interest are listed on the NASDAQ Capital Market (NASDAQ-CM), which caters to early-stage companies with relatively low market capitalization. Others trade on the NYSE AMEX, long a favorite of OTC issuers that “graduate” to an exchange. 

Some firms offering this type of financing to exchange-listed companies are sophisticated and have deep pockets. However, the techniques they employ deliver the same results as those enjoyed by OTC Markets toxic lenders. Jacob Ma-Weaver of Cable Car Capital, LLC, one of the earliest commenters on the amendments to Rule 144, made some salient points:

I support this well-considered proposal, which may help discourage capital structures that are frequently associated with microcap fraud and market manipulation.

However, I believe the proposed amendment to the rule 144 holding period for market-based convertible securities should not be limited to unlisted issuers. The limited protections provided by exchange listing standards are insufficient to address the issue at hand, which is that the acquirer of the convertible security acted as an underwriter and acquired securities with an intent to distribute and did not bear investment risk. Shareholder approval of such a transaction does not change the risk or economic character of the selling security holders investment. While less frequent than among unlisted issuers, there are examples of listed issuers whose shareholders approved highly dilutive transactions or where favored insiders or financiers purchased privately placed securities with ratchet features not available to public stockholders. Exempting listed issuers could also create an illogical situation whereby a privately acquired market-based convertibles holding period would be satisfied the moment a previously unlisted security became exchange-traded, creating both the incentive and opportunity for an unregistered distribution in connection with initial listing.

(“Full ratchet” refers to a type of anti-dilution protection for preferred stock in the event of a down round of series financing that adjusts the number of common shares the preferred shares can be converted into based on the new share price.)

Convertible financing has a legitimate place in our capital markets, but it should not involve market-adjustable securities. Under-capitalized companies do need access to financing, but floorless convertibles all too often destroy the issuers who agree to issue them. 

The SEC has done a good job promoting Regulation A offerings. Private placements of several kinds are available to OTC Markets and exchange-listed issuers alike, as are Form S-1 offerings, though not all issuers are ready to register a class of stock and comply with filing obligations. While these are, for the issuer, less certain and more complicated than signing a stock purchase agreement presented by a toxic funder, they are, in the long run, also far less dangerous. 


To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. 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 Attorneys
Brenda Hamilton, Securities Attorney
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