I’ve been at this for a long time and although some things do not change, the securities industry has been a roller coaster of change from rule amendments to guidance, to interpretation, and nuances big and small that can have tidal wave effects for market participants. On December 22, 2020, the SEC proposed amendments to Rule 144 which would eliminate tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange. The proposed rule also updates the Form 144 filing requirements to mandate electronic filings, eliminate the requirement to file a Form 144 with respect to sales of securities issued by companies that are not subject to Exchange Act reporting, and amend the Form 144 filing deadline to coincide with the Form 4 filing deadline.
The last amendments to Rule 144 were in 2008 reducing the holding periods to six months for reporting issuers and one year for non-reporting issuers respectively, adding current information requirements and eliminating the use of the rule for shell companies and former shell companies unless certain preconditions were satisfied. For a summary of the current Rule 144, see HERE.
Currently, Rule 144 deems securities acquired solely in exchange for other securities of the same issuer to have been acquired at the same time as the securities surrendered for conversion or exchange. Under the amendments, the holding period for the underlying securities acquired upon conversion or exchange of “market-adjustable securities” would not begin until the conversion or exchange. Market adjustable securities usually take the form of convertible notes which had become a very popular and common form of financing for micro- and small-cap public companies over the past decade or so – that is, until the SEC went on the attack starting a few years ago recently intensifying those efforts.
In a standard convertible note structure, an investor lends money in the form of a convertible promissory note. Generally the note can either be repaid in cash, or if not repaid, can be converted into securities of the issuer. As Rule 144 allows for tacking of the holding period, as long as the convertible note is outstanding for the requisite holding period, the investor would be able to sell the underlying securities into the public market immediately upon conversion. The notes generally convert at a discount to market price so if the converted securities are sold quickly, a profit is built in. The selling pressure from the converted shares has a tendency to push down the stock price of the issuer.
The notes also generally have an equity blocker (usually 4.99%) such that the holder is prohibited from owning more than a certain percentage of the company at any given time to ensure they will never be deemed an affiliate and will not have to file ownership reports under either Sections 13 or 16 of the Exchange Act (for more on Sections 13 and 16 see HERE). As a result, there is the potential for a note holder to require multiple conversions each at 4.99% of the outstanding company stock. Each conversion would be at a discount to the market price with the market price being lower each time as a result of the selling pressure. This can result in a very large increase in the number of outstanding shares and a drastic decrease in the share price. Over the years this type of financing has often been referred to as “toxic” or “death spiral.”
Extreme dilution is really only possible in companies that do not trade on a national securities exchange. Both the NYSE and Nasdaq have provisions that prohibit the private issuance of more than 20% of total outstanding, of discounted securities without prior shareholder approval. For more on the 20% Rule, see HERE. In addition to protecting the shareholders from dilution, the 20% Rule is a built-in blocker against distributions and as such, the SEC proposed rule change only includes securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange. The SEC also notes, correctly, that the exchanges do not look favorably on transactions involving market adjustable securities and as such, it is more difficult for an issuer to satisfy the listing criteria if they are or have been engaged in such transactions.
Although on first look it sounds like these transactions are risk-free for the investor, they are not. First, Rule 144 itself creates some hurdles. In particular, in order to rely on the shorter six-month holding period for reporting companies, the company must be current in its reporting obligations. Also, if the company was formerly a shell company, it must always be current in its reporting obligations to rely on Rule 144. If a company becomes delinquent, the investor can no longer convert its debt and oftentimes such a company does not have the cash to pay back the obligation. Further, over the years it has become increasingly difficult to deposit the securities of penny stock issuers. Regardless of whether Rule 144 requires current information, most brokerage firms will not accept the deposit of securities of a company without current information, and many law firms, including mine, will not render an opinion for the securities of those dark companies.
The SEC recognizes these risks noting that a holder of market adjustable securities is subject to risk in the period from the issuance of the securities until the holding period is satisfied (such as a company going dark) but are not exposed to market risk associated with the underlying securities after conversion. In these circumstances, holders that convert and promptly resell the underlying security in order to secure a profit on the sale based on the built-in discount have not assumed the economic risks of investment of the underlying security. The SEC sees this as inconsistent with the purpose of Rule 144 to provide a safe harbor for transactions that are not distributions of securities.
The potential for profit attracted some unscrupulous market participants (especially in the early years), which together with the fact that the financing is expensive for companies, made the entire industry one that certain players in the small-cap world love to hate. From my viewpoint, the two sides of the coin became as polarized as partisan politics. An almost evangelical faction arose determined to stop these “predatory lenders,” likening them to the leg-breaking loan sharks of the 1960’s. On the other side, there are also higher-quality lenders that seek out a better-quality company to invest in and work to become long-term financial partners making multiple investments over the years mounting to millions of dollars helping companies grow. For many micro-cap companies, these lenders have become an indispensable source of capital where few or no other options exist.
I applaud every regulatory step in the direction of cleaning up the micro-cap space and giving OTC Markets respect as the venture marketplace it is, but in some cases the proverbial baby gets thrown out with the bath water. This isn’t the first time that the SEC has taken action to limit market adjusted financing. Back in 2006 the SEC altered its interpretation of Rule 415 limiting the amount of securities that could be registered as resale to 30% of a company’s public float (see HERE. Prior to that, big players like Cornell Capital and Dutchess Capital wrote ELOC’s for every micro-cap company in town.
Market adjusted investments dissipated for a little while but then the Rule 144 changes in 2008 (coupled with the allowance of tacking from 1997) brought it back to life. The 1997 Rule 144 proposing rule release proposed codifying the Division of Corporation Finance’s position that, if the securities to be sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms. However, investors still thought a two-year hold was too long. Then the 2008 rule changes shortened the holding period for restricted securities to six months for reporting companies and one year for non-reporting companies and overnight, the convertible note lending business blossomed.
The SEC certainly had visibility on the business as most of the issuers were publicly reporting and had to not only file an 8-K upon entering into a transaction but are required to report derivative liabilities on their balance sheets for the convertible overhang and to detail the transactions in the notes to financial statements. Back on September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the release of these actions, I had been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and in particular to determine 8-K filing deficiencies. See HERE for my blog at the time.
At the time the SEC did not take aim at the investors and the only enforcement actions against investors’ involved fraud or market manipulation. Then in November 2017, the SEC shocked the industry when it filed an action against Microcap Equity Group, LLC and its principal alleging that its investing activity required licensing as a dealer under Section 15(a) of the Exchange Act. Since that time the SEC has filed approximately four more cases with the sole allegation being that the investor acted as an unregistered dealer.
The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question. So far the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes. Although there is a long-standing legal premise that a dealer in a thing must buy and sell the same thing (a car parts dealer is not an auto dealer, an icemaker is not a water dealer, etc.), there is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded.
Specifically, there is no precedent for the theory that if you trade in convertible notes instead of open market securities, private placements instead of registered deals, bonds instead of stock, or warrants instead of preferred stock, etc., you either must be licensed as a dealer or are exempt. Again, the entire community that serially invests or trades in public companies is in a state of regulatory uncertainty and the capital flow to small- and micro-cap companies has diminished accordingly. Although the SEC has had some wins in the litigations, the issue is far from settled.
In that regard, the new Rule 144 proposal provides comfort in some respects. First, it is a step in regulating through rules and guidance as opposed to enforcement. Second, it seems to indicate that the SEC enforcement proceedings alleging unregistered dealer activities have specifically targeted market adjusted investment instruments that are not exchange traded as opposed to all private traders and investors.
After this long introduction, I’ll turn to the proposed rule.
Elimination of Tacking for Market Adjustable Securities
All offers and sales of securities in the US must either be registered or there must be an available exemption from registration. The Securities Act of 1933 (“Securities Act”) Rule 144 sets forth certain requirements for the use of the Section 4(a)(1) exemption for the resale of securities. Rule 144 is a non-exclusive safe harbor for reliance on Section 4(a)(1). Section 4(a)(1) of the Securities Act provides an exemption for a transaction “by a person other than an issuer, underwriter, or dealer.” Section 2(a)(11) in turn defines an underwriter as any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security or participates or has a direct or indirect participation in any such undertaking.
Rule 144 sets forth objective criteria, including holding periods, public information, manner of sale, etc. on which selling security holders may rely to avoid being deemed to be engaged in a distribution and, therefore, to avoid acting as an underwriter under Section 2(a)(11) of the Securities Act. The holding period requirement is meant to ensure that the holder has assumed the economic risks of the investment and is not just acting as a conduit for the sale of unregistered securities to the public. When all of the conditions of Rule 144 are complied with, the purchaser of securities receives freely tradeable, unrestricted securities. Rule 144 only addresses the resale of restricted or control securities. Unrestricted securities (such as securities that have been registered under the Securities Act) may be sold without reference or regard to the Rule.
As discussed above, Rule 144 deems securities acquired solely in exchange for other securities of the same issuer to have been acquired at the same time as the securities surrendered for conversion or exchange. As a result, holders of market adjustable securities, such as a convertible note, may convert the note into common stock and immediately resell that common stock into the public marketplace, as long as the note has been held for the requisite Rule 144 holding period. Since the note is converted at a price below the market price, there is a built-in profit. Multiple conversions and sales can dramatically increase the amount of outstanding stock. This can be seen as a loophole in the rule’s structure resulting in distributions of securities, despite the compliance with Rule 144. The proposed rule change is intended to close this hole.
Currently Rule 144(d) sets out the holding period requirements to satisfy Rule 144. Rule 144(d)(3)(ii) provides “Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms.” The proposed rule change would amend Rule 144(d)(3)(ii) to eliminate “tacking” for securities acquired upon the conversion or exchange of the market-adjustable securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange. As noted above, the rule change would not capture exchange traded securities as the exchanges already have rules to prevent distributions without prior shareholder approval (see the 20% rule – HERE.
The new proposed Rule 144(d)(3)(ii) language is as follows:
(ii) Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms, unless:
(A) the newly acquired securities were acquired from an issuer that, at the time of conversion or exchange, does not have a class of securities listed, or approved for listing, on a national securities exchange registered pursuant to Section 6 of the Exchange Act (15 U.S.C. 78f); and
(B) the convertible or exchangeable security contains terms, such as conversion rate or price adjustments, that offset, in whole or in part, declines in the market value of the underlying securities occurring prior to conversion or exchange, other than terms that adjust for stock splits, dividends or other issuer-initiated changes in its capitalization.
As a result, the holding period for the underlying securities, either six months for securities issued by a reporting company or one year for securities issued by a non-reporting company, would not begin until the conversion or exchange of the market-adjustable securities. The proposed rule change would not include convertible securities that have provisions for adjustments for splits, dividends, or other issuer initiated changes in capitalization but were not otherwise market adjustable.
Forms 4, 5, and 144 Filing Requirements
The rule proposal would: (i) mandate the electronic filing of Form 144; (ii) eliminate the Form 144 filing requirement related to the sale of securities of issuers that are not subject to the reporting requirements of the Exchange Act; (iii) amend the Form 144 filing deadline so that Form 144 may be filed concurrently with Form 4 by persons subject to both filing requirements; and (iv) amend Forms 4 and 5 to add an optional check box to indicate that a reported transaction was intended to satisfy Rule 10b5-1(c), which provides an affirmative defense for trading on the basis of material non-public information in insider trading cases.
The SEC plans to make an online fillable Form 144 available to simplify electronic filing and to streamline the electronic filing of Forms 4 and 144 reporting the same sale of securities.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC 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, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with 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; 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 American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA 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 small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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