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by Laura Anthony, Esq.

The Securities & Exchange Commission (SEC) Provides Guidance Regarding Section 3(a)(10) of the Securities Act of 1933

Section 3(a)(10) of the Securities Act of 1933, as amended (“Securities Act”) is an exemption from the Securities Act registration requirements for the offers and sales of securities by Issuers. The exemption provides that “[E]xcept as hereinafter expressly provided, the provisions of this title [the Securities Act] shall not apply to any of the following classes of securities….(10) Except with respect to a security exchanged in a case under title 11 of the United States Code, any security which is issued in exchange for one or more bona fide outstanding securities, claims or property interests, or partly in such exchange and partly for cash, where the terms and conditions of such issuance and exchange are approved, after a hearing upon the fairness of such terms and conditions at which all persons to whom it is proposed to issue securities in such exchange shall have the right to appear, by any court, or by any official or agency of the United States, or by any State or Territorial banking or insurance commission or other governmental authority expressly authorized by law to grant such approval.”

The Securities and Exchange Commission (SEC) has given guidance on the operation of Section 3(a)(10) in its Division of Corporation Finance: Revised Staff Legal Bulleting No. 3. In particular, in order to rely on the exemption, the following conditions must be met:

  • The securities must be issued in exchange for securities, claims, or property interests, not cash;
  • A court or authorized governmental entity must approve the fairness of the terms and conditions of the exchange;
  • The reviewing court or authorized governmental entity must (i) find that the terms and conditions of the exchange are fair to those that the securities will be issued to; and (ii) be properly advised that the Issuer will be relying on the court’s findings to issuer securities;
  • The reviewing court or authorized governmental entity must hold a hearing before approving the fairness of the terms and conditions of the transaction;
  • A governmental entity must be expressly authorized by law to hold the hearing;
  • The fairness hearing must be open to everyone to whom securities would be issued in the proposed exchange;
  • Adequate notice must be given to all those persons; and
  • There cannot be any improper impediments to the appearance by those persons at the hearing.

In addition to complying with the above conditions, Issuers should be aware that many state securities law statutes that authorize a Section 3(a)(10) court process, require that there be a majority shareholder vote approving the transaction, prior to the hearing.

Importantly SEC Staff Bulletin 3 provides that the re-sale of securities issued in a Section 3(a)(10) transaction may be had without regard to Rule 144 if the seller is not an affiliate of the Issuer either before or after the Section 3(a)(10) transaction. If the seller is or will be an affiliate either before or after the Section 3(a)(10) transaction, re-sales may be made in accordance with Rule 144, except for the holding period and notice filing requirements. That is, affiliates would still be subject to the drip rules, manner of sale and current public information requirements.

As a practical matter, many over the counter traded securities (Over the Counter Bulletin Board or OTCBB and Pink Sheets) have been utilizing the exemption found in Section 3(a)(10) to convert debt into common stock. The conversion of debt into common stock can assist an Issuer in two ways. First, and obviously, it eliminates the debt from the balance sheet and increases liquidity and solvency. Second, and less obvious, is that the Section 3(a)(10) exemption can be used to convince lenders to make investments into a company, without the investor relying solely on the Company cash flows for repayment.

Moreover, in these trying economic times, it seems there is the potential for a substantial increase in the use of this exemption by OTCBB and Pink Sheet Companies as a tool to clean up their balance sheets and induce additional capital investments. In fact, the hearing process can be quick and relatively inexpensive. The court must only opine on the fairness of the transaction to those that the securities will be issued, the creditor whose debt will be exchanged for stock.

The court does not render their decision based upon the potential impact on the shareholders of record, the Company or the potential marketplace shareholders. In most cases the creditor is highly motivated to convert its debt into common stock and realize the opportunity for immediate cash through resale or the opportunity for long-term gain through holding the stock.

As with the use of all registration exemptions, Issuers are cautioned that they are still subject to the anti-fraud, civil liability and other provisions of the federal securities laws. Moreover, Section 3(a)(10) is not available to exempt any transaction that is in part of a plan or scheme to evade the registration provisions of the Act. In any of these cases, registration under the Act is required unless another exemption is available.

Securities attorney Laura Anthony provides expert legal advice and ongoing corporate counsel to small public Companies as well as private Companies seeking to go public on the Over the Counter Bulletin Board Exchange (OTCBB). Ms. Anthony counsels private and small public Companies nationwide regarding reverse mergers, due diligence on public shells, corporate transactions and all aspects of securities law.

Attorney Laura Anthony is a Florida securities attorney and the Founding Partner of Legal & Compliance, LLC, a national corporate, securities and civil litigation law firm based in West Palm Beach, Florida. The Florida corporate and securities attorneys of Legal & Compliance offer specialized legal services to small and mid-size private and public (OTCBB) companies, entrepreneurs, and business professionals throughout the country. Contact us today for a FREE consultation!