Understanding Section 3(a)(9) Exchanges and Conversions as Related to Convertible Promissory Notes

As an attorney specializing in the representation of companies and investment funds in the micro, small and mid cap arena, we work on corporate financing transactions involving convertible debt almost daily.  These transactions provide a tremendous amount of benefit to these small cap companies, in that they obtain cash today that will be repaid with common stock tomorrow.  Financing using convertible instruments that are repaid with stock is one of the many reasons an entity may choose to go public.  However, the financing comes at a price including both dilution to existing stockholders and likely a reduced stock price resulting from the selling pressure when the debt is converted.  Of course, all financing has pros and cons and public entities need to consider all the facts and circumstances in making corporate finance transaction decisions.  This blog provides some basic information on the securities law that supports convertible financing transactions and a basic refresher on convertible promissory notes.

 Section 3(a)(9) of the Securities Act of 1933

 Section 3(a)(9) of the Securities Act of 1933 provides an exemption from the registration requirements of Section 5, and in particular exempts transactions as follows: “[E]xcept with respect to a security exchanged in a case under title 11 of the United States Code, any security exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange.” 

Since Section 3(a)(9) is a transactional exemption, the new securities issued are subject to the same restrictions on transferability, if any, as the old securities, and any subsequent transfer of the newly issued securities will require registration or another exemption from registration.  However, since the new securities take on the character of the old securities, tacking of a holding period is generally permitted, allowing for subsequent resales under Rule 144 (assuming all other conditions have been satisfied for use of such rule). 

In particular, Rule 144(d)(3)(ii) provides that where securities are acquired from an issuer solely in exchange for other securities of the same issuer, the newly acquired securities may tack onto the holding period and shall be deemed to have been acquired at the same time as the securities surrendered for conversion, even if the securities surrendered were not convertible or exchangeable by their terms.  Moreover, in accordance with Rule 144, even if a promissory note does not have a conversion feature, the issuer and investor can agree to conversion terms and still benefit from a tacking on the holding period.

Section 3(a)(9) exchanges have gained in popularity as many investors are willing to fund public companies with convertible promissory notes which notes convert into freely tradable stock upon expiration of the Rule 144 holding period, again assuming all other conditions are satisfied.  For more information regarding the satisfaction of other conditions (such as non-affiliate status of the shareholder, current information by the issuer, shell status of the issuer, etc.), please see my blog on Rule 144 posted here.

Moreover,  Section 3(a)(9) exchanges can be used to reduce interest payments or accruals (by exchanging high-rate debt for lower-rate debt or by exchanging accrued interest or preferred payments for equity); reduce or eliminate outstanding debt (by exchanging debt for equity) and to modify the terms of existing securities (for example, modifying conversion ratios and redemption provisions). 

The advantages of a Section 3(a)(9) exchange include: (i) they can be completed quickly as there is no registration required; (ii) are flexible (an issuer can retire partial or entire liabilities); (iii) minimal costs; and (iv) often can be accomplished largely tax-free for debt holders.  The disadvantages include: (i) the new securities may be restricted depending on the status of the old securities offered in exchange or the availability of Rule 144 tacking of a holding period; and (ii) no commissions or other compensation can be paid, such as to a broker or investment banker. 

The four main requirements of a Section 3(a)(9) exchange are as follows:  (i) same issuer – the issuer of the old securities being surrendered must be the same as the issuer of the new securities; (ii) no additional consideration from the security holder; (iii) offer must be made exclusively with existing security holders; and (iv) no commission or compensation may be paid for soliciting the exchange. 

Section 3(a)(9) exempts any securities exchange by the issuer with its security holders.  This means that the new securities being issued and the securities that are being surrendered must be from the same issuer.  The “same issuer” can at times be a successor issuer.  The SEC has taken the position that where an issuer has fully and unconditionally assumed the obligations of the debt securities of another issuer, the subsequent exchange of that debt by the successor issuer qualifies as a Section 3(a)(9) exchange.  The successor issuer has become the “issuer” by fully and unconditionally assuming the obligation. 

A parent and subsidiary are generally considered two separate issuers.  Accordingly, if a subsidiary proposes to exchange debt that is guaranteed by the parent for debt that is not guaranteed by the parent, the exchange would not qualify under Section 3(a)(9). However, the SEC has granted no-action relief for parent/subsidiary exchange transactions in particular fact circumstances. 

The prohibition against paying commission or other compensation for the solicitation of an exchange does not include the payment of administrative or ministerial fees solely for document preparation, mailing or legal opinions. 

Convertible Promissory Notes

As a basic primer, a promissory note is a written promise by a person, persons or entity to pay a specific amount of money (called “principal”) to another, usually to include a specified amount of interest on the unpaid principal amount.  In addition, a promissory note will include the specifics of the debt, including the debtor and creditor, when payment or payments are due; interest rates, if the debt is secured; and whether the debt may be converted into stock or other equity.  A promissory note that may be converted is often referred to as either a debenture or a convertible promissory note.

Convertible promissory notes offer flexibility for financing for a small public company.  Generally both the investor/lender and public company/borrower anticipate that the conversion option will indeed be used for repayment of the debt.  However, the lender has the comfort of knowing that if the conversion option is not viable, the debt is still owed in cash.  Securities laws require that there either be an effective registration statement or exemption to registration at the time of conversion.  Securities Act Rule 3(a)(9) is the exemption usually relied upon.

Historically lenders in a convertible promissory note required that the small public company file a registration statement to register the underlying securities.  Upon effectiveness of the registration statement, the lender can convert all or a portion of the debt, depending on the negotiated terms of the note, into common stock and sell the stock in the public market place to recoup their original investment.  A convertible promissory note is often the investment vehicle used in a PIPE investment.  However, since the amendments to Rule 144 in early 2008 shortening the holding period available for the securities of reporting public companies to six months, many lenders are willing to forgo the registration requirement and hold the Notes for the six month period.  Accordingly since 2008 and increasingly so in recent years, financing through convertible promissory notes, without a registration requirement, has become an increasingly popular investment and financing vehicle in the small cap market place.

The convertible note will set a conversion price which is negotiated between the lender/investor and borrower/public company at the time of issuance.  Generally, the note is convertible into common stock at a discount to the market price of the stock at the time of conversion.  In my experience, the negotiated discount can vary widely.  A public company with greater liquidity, strong market support, strong financial statements, and the like would be in a position to negotiate a smaller discount such as 15-25%, whereas a public company without these benefits may have to agree to a much higher discount such as 35-50%.

Although this type of financing serves many purposes in the capital markets and is fairly easily obtained, small public companies should be aware of the disadvantages.  For instance, a convertible promissory note which is partially converted or converted in tranches has the tendency to drive the price of a security down while exponentially increasing the amount of stock in the public float.  For example, if the security is priced at $1.00 and the lender/investor converts $10,000 of debt and immediately sells those securities into the public market, that very selling pressure may drive down the price.  When the lender converts the next $10,000 in debt at a lower price, say $.80, they would get more common stock to cover the same amount of debt.  Upon selling this stock, again, the selling pressure would drive down the price.  as the lender/investor continues to convert into more and more stock to cover the same amount of debt, and sell such stock, the price would be driven down further and further.  Moreover, the amount of stock in the public float would continue to increase, resulting in dilution to the current shareholders and making it much more difficult for the same stock to see an upward movement in its price.   

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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