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The Sale of Unregistered Securities Must Satisfy Form 8-K Filing Requirements In a 3(a)(10) Transaction

Introduction and Background

Recently the Securities and Exchange Commission (“SEC”) has been taking action against public reporting companies for the failure to file a Form 8-K upon the completion of a transaction exempt under Section 3(a)(10) of the Securities Act of 1933, as amended (“Securities Act”).  The SEC has served a Wells notice on numerous companies for the failure to file such Form 8-K without any prior communication with such companies. Since enforcement actions for the failure to file a Form 8-K are very rare, it is my view that the SEC is concerned with the 3(a)(10) transaction itself.

A Wells notice, often referred to as a Wells letter, is a notice delivered by the SEC to persons and entities under investigation providing the opportunity to such persons and entities to present their position to the SEC prior to the commencement of an enforcement proceeding.  A Wells letter gives notice of the SEC’s intended charges and enforcement recommendation and affords the recipient an opportunity to submit a defensive statement.  Moreover, a Wells letter often precipitates settlement discussion between the SEC and the enforcement target.

The Wells notice procedure is not codified in formal rules but rather is an informal process that has become widely used since its inception in 1972.  Generally, the SEC gives the target an opportunity to submit a defensive written statement or videotape recording within some arbitrary period of time, based on the facts and circumstances, prior to the filing of an enforcement proceeding.

In the case of the current wave of Wells notices for the failure to file a Form 8-K for a 3(a)(10) transaction, the process has been pretty cut-and-dry.  If the target company did not file the Form 8-K, the SEC will give them an opportunity to file the missing form, pay a monetary penalty and agree to a settlement order, or face an enforcement proceeding.  The current penalty for violations of the Exchange Act reporting requirements is $66,000 per violation; however, the SEC is negotiable both in amount and payment terms.

It seems that if the SEC had found other actionable violations by these target companies associated with the 3(a)(10) action, the Wells notice would include such other actions; however, it is not required to.  The SEC can pursue enforcement actions for all violations of the securities laws and is not required to aggregate such actions into a single investigation or proceeding.  Moreover, the SEC may be using these out-of-the-ordinary enforcement actions as a way of sending a message to the small cap community that it is aware of the popularity of these 3(a)(10) actions, is reviewing them for securities laws compliance, and will pursue enforcement proceedings where available.

Section 3(a)(10) Transactions

Section 3(a)(10) of the Securities Act is an exemption from the Securities Act registration requirements for the offers and sales of securities by issuers.  The exemption provides that “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.”  Section 3(a)(10) does not preempt state law and accordingly, the implementing state statutes must also be abided by.

The SEC has given guidance on the operation of Section 3(a)(10) in its Division of Corporation Finance: Revised Staff Legal Bulletin 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.

Importantly, SEC Staff Bulletin 3 provides that the resale 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.  That is, as long as the seller is not an affiliate of the issuer, securities issued in a 3(a)(10) transaction are freely tradable. Since a Section 3(a)(10) transaction does not include a Rule 144 analysis, there are no Rule 144 holding period requirements. 

If the seller is or will be an affiliate either before or after the Section 3(a)(10) transaction, resales are subject to Rule 144, except for the holding period and notice filing requirements.  Affiliates would still be subject to the drip rules, manner of sale and current public information requirements, but not the holding period requirements.

As a practical matter, many over-the-counter traded securities (over-the-counter bulletin board or OTCBB and pinksheets) have been utilizing the exemption found in Section 3(a)(10) to convert all forms of debt into freely tradable common stock.  The conversion of debt into common stock can assist the company in two ways.  First, and obviously, it eliminates the debt from the balance sheet and increases liquidity and solvency.  Second, and less obviously, 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.

Unlike Section 3(a)(9) conversions, Section 3(a)(10) can be used for any debt or claim, not just another security.  Accordingly, Section 3(a)(10) can be used to settle trade payables such as office supply invoices, transfer agent fees, EDGAR fees and all forms of expenses incurred in the company’s operations.  Since many vendors are not interested in selling stock in return for payment, and since many of these invoices would be too small to warrant a court proceeding, a group of corporate finance professionals have made a business of buying and aggregating available debt and completing 3(a)(10) transactions with companies.  The process is straightforward.  A company assists the potential 3(a)(10) creditor in identifying and purchasing all or a part of the company’s outstanding debt following which a lawsuit is filed and a hearing completed meeting the requirements of Staff Bulletin 3.  The same company can complete the same process multiple times as it continues to operate and incur operating expenses.

Moreover, as long as the requirements of Staff Bulletin 3 are met, the company and the creditor can fashion the 3(a)(10) transaction any way they see fit.  The trend has been to fashion an agreement that looks substantially like a convertible promissory note with takedowns of the debt by the creditor priced at a discount to market and subject to an ownership limitation to avoid affiliation.

This structure has a tendency to drive down the company’s stock price and result in substantial dilution to existing stockholders.  For example, if the security is priced at $1.00 and the 3(a)(10) creditor 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 3(a)(10) creditor converted 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 3(a)(10) creditor continues to convert into more and more stock to cover the same amount of debt, and sell such stock, the price is driven down further and further.  Moreover, as the shares are freely tradable, the amount of stock in the public float continues 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.

For industry professionals it is easy to see why this process has garnered SEC attention.  Large volumes of unregistered securities are being sold into the public markets with the only disclosure requirement being a Form 8-K.

Form 8-K Filing Requirement for a 3(a)(10) Transaction

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file reports with the SEC (“Reporting Requirements”).  For an overview of these reporting requirements, see my blog Here.

Sections 13(a) and 15(d) of the Exchange Act are the broad statutory provisions requiring the filing of reports by companies registered under the Exchange Act and Securities Act respectively.  The Section 13 rules promulgated under the Exchange Act enumerate the specific required reports including annual Form 10-K, quarterly Form 10Q’s and current periodic Form 8-K.

Exchange Act Rule 13a-11 requires the filing of current reports on Form 8-K.  Subject to certain exceptions, a Form 8-K must be filed within four (4) business days after the occurrence of the event being disclosed.  No extension is available for an 8-K.  Companies file this report with the SEC to announce major or extraordinary events that shareholders should know about, including entry into material agreements and the issuance of unregistered securities.  It is these two specific events that are implicated with a 3(a)(10) transaction.

In particular, Item 1.01 of Form 8-K requires that a company report if it has entered into “a material definitive agreement not made in the ordinary course of business…”  Under Item 1.01, the company must report: (a) the date of the agreement; (b) the parties to the agreement; (c) a description of any material relationship between the parties, other than the reported agreement; and (d) a brief description of the terms and conditions of the agreement.  As described, a 3(a)(10) transaction involves the entry into an agreement setting forth the terms of the exchange.  That agreement is generally in the form of a settlement agreement which is approved in the court hearing, but regardless of the title of the agreement, the end result is an agreement between the company and the 3(a)(10) creditor, and that agreement requires the filing of an 8-K under Item 1.01.

Item 3.02 of Form 8-K requires that a company report the unregistered sale of securities.  Under Item 3.02, the company must report the unregistered sale of securities if the sale constitutes 5% or more of the outstanding securities.  The report must disclose: (a) the date, title and amount of securities sold; (b) the nature and amount of consideration paid; (c) the Securities Act exemption being relied upon and a brief explanation of the facts relied upon to support the exemption; and (d) where applicable, the terms of conversion or exercise.

Although the vast majority of 3(a)(10) settlement agreements are structured as tranche issuances, the Item 3.02 filing requirement is triggered if the volume threshold of the underlying equity securities issuable upon conversion is exceeded, even if those issuances are structured as takedown or tranche payments.  That is, if it is foreseeable that the total number of securities issued in the 3(a)(10) transaction will exceed 5% of the current outstanding securities, an Item 3.02 8-K must be filed.  Most 3(a)(10) transactions trigger this filing requirement.

The Author

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

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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