On August 19, 2024, SEC Commissioner Mark T. Uyeda published a statement regarding one of the numerous defendants in SEC initiated enforcement proceedings claiming unlicensed dealer activity. The statement resonates with the sentiments of most of my colleagues, peers and clients.
Background
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 numerous additional cases with the sole allegation being that the investor acted as an unregistered dealer. In each case, the investor entity purchased convertible promissory notes from micro-cap OTC Markets issuers (or other existing note holders), which, after the applicable Rule 144 holding period, were converted into shares of common stock and sold on the open market. As the securities were generally low priced, the conversions resulted in large quantities of additional shares being sold into the marketplace.
The primary defense has been that the enforcement actions are an arbitrary and capricious interpretation of the dealer statute and that the defendant’s had no reasonable grounds in which to conclude their activity could require licensing as a dealer.
The SEC certainly knew of the proliferation of convertible note and other market adjustable securities financings over the years. Rule 415 governs the registration requirements for the sale of securities to be offered on a delayed or continuous basis, such as in the case of the take down or conversion of convertible debt and warrants. In 2006 the SEC issued guidance on Rule 415 that the rule would not be available for re-sale registration statements where in excess of 30% of the company’s float was being registered for re-sale. The SEC indicated it would view such registrations as indirect primary offerings, that could not be priced at the market. The SEC action was in direct response to the proliferation of market adjustable equity line of credit financings during that time. Although there were a few large investors that did the majority of the financings, the SEC did not raise the dealer issue.
Moreover, back in 1997, the SEC amended Rule 144 to specifically allow for the tacking of a holding period when converting convertible securities. At that time, the rule amendment contained an in-depth discussion of convertible note (and convertible preferred stock) financing. The rule did not mention that investors could be considered “dealers” as defined by the Exchange Act. Likewise, the 2008 Rule 144 amendments that reduced the holding periods to six months and one year also addressed convertible financing and added a provision to clarify that tacking is also allowed upon the exercise of options and warrants where there is a cashless exercise feature. Again, the SEC did not raise an issue that the most prolific investors could be acting as an unlicensed dealer. To the contrary, the SEC recognized the importance of this type of financing.
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 announcement 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 to determine 8-K filing deficiencies. See HERE for my blog at the time. The SEC did not mention any potential violations by the investors themselves.
Nothing in the prior SEC rule making, interpretive guidance, or enforcement actions foresaw the current dealer litigation issue. 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 in penny stock issuers. 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 or the size of the issuer (i.e. penny stocks).
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. Likewise, there is nothing in the broker dealer regime that suggests that if you invest in penny stock issuers vs. middle market or exchange traded entities you need to be licensed as a dealer.
In fact, the numerous and prolific convertible note investors into small-cap exchange traded companies have yet to face enforcement proceedings. Presumably that is because most of those investments are registered and the national exchanges require a floor price on the conversion price. However, there is nothing in the dealer statute, rules, guidance, interpretations or the like that distinguishes between registered or unregistered deals or conversion prices.
In December 2020, the SEC proposed an amendment to Rule 144 to eliminate the tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange (see HERE). Certainly, this was a step toward regulating the issue, the plethora of negative comment letters stalled the potential rule change, though it still remains on the proposed list of the SEC regulatory agenda. For numerous reasons, the proposed rule change should be stalled or eliminated, however the SEC seems to be circumventing the rule making completely by pushing forward with enforcement proceedings.
To add to the frustration, earlier this year, the SEC adopted final new rules amending the definition of a “dealer” under the Exchange Act and specifically declined to provide regulatory clarity related to convertible security investors in the small-cap and penny stock space (see HERE). Unfortunately for market participants, the SEC was unapologetic concerning its failure to provide guidance to the myriad of small-cap lenders/investors that are now engaged in litigation or under investigation. The SEC hedges, stating that “the final rules are one way to establish that a person is a dealer or government securities dealer; otherwise applicable court precedent and Commission interpretations will continue to apply.” To drive the point home, the final rule itself contains a provision stating that “no presumption shall arise that a person is not a dealer or government securities dealer solely because that person does not satisfy the standards of the final rules.”
On August 19, 2024, the SEC announced the settlement of a “dealer” enforcement proceeding against GHS Investments and its principals prompting Commissioner Uyeda to issue a statement.
Commissioner Mark T. Uyeda’s Statement
Commissioner Uyeda gets straight to the issue – that the SEC is regulating by enforcement. Commissioner Uyeda points out that that since at least the 1990’s (as an aside it has been much longer than that), companies have issued convertible, variable rate notes to finance their operations. The conversion of those notes can result in dilution and a suppression of the company’s stock price, but the company understands the risk prior to accepting the investment. In fact, generally such convertible notes were the only source of available financing. Commissioner Uyeda continues “[A]lthough the Commission has not publicly expressed it, its enforcement actions suggest policy concerns with investors’ actions relating to convertible, variable rate notes and such actions’ impact on the share prices of companies that issue them. However, the appropriate course of action to address these concerns is through rulemaking, not enforcement.”
Commissioner Uyeda points out that the proposed Rule 144 amendments would achieve the unspoken policy objective regarding convertible, variable rate notes. However, without the final rule, the SEC continues to regulate the issue by enforcement.
Moving on, Commissioner Uyeda rightly states that the numerous “dealer” cases introduced a novel interpretation that such activities (convertible variable rate notes) meant that investors were “dealers” and needed to register under the Exchange Act. Further, “[P]rior to 2017, investors in convertible, variable rate notes had no reason to believe that their activity could trigger dealer registration obligations. One might claim that market participants should have been on notice about the Commission’s previously undisclosed interpretation of “dealer” when it filed the first complaint in 2017. However, it is unreasonable to expect market participants to be continuously scanning court dockets in pending litigation across the country for new legal theories from the Commission, and on which a court has never ruled.”
Although the first proceeding was initiated in 2017, rulings on the enforcement actions did not begin until late 2019 and 2020 – generally reflecting wins by the SEC. In the case of GHS, the SEC recognized that they stopped purchasing new convertible notes in 2020 and only converted small amounts of stock from existing inventory thereafter. In other words, GHS stopped the conduct in question around the time that the first judicial opinions stating that such conduct triggered dealer registration requirements was issued. In light of this, holding GHS to a standard not articulated until after its conduct occurred is fundamentally unfair.
Moving onto the arbitrary enforcement issue, Commissioner Uyeda notes that under the SEC’s “broad definition of “dealer,” nearly any activity that involves buying and selling securities outside of the trader exception could require registration under the Exchange Act. Yet the action against GHS [and all the other defendant litigants] is solely focused on its transactions involving convertible, variable rate notes.”
In addition to notes, GHS also acquired shares of common stock at a discounted price pursuant to equity lines of credit and then sought to resell them at prevailing market prices pursuant to registration statements under the Securities Act. In fact, GHS is a prolific equity line investor. However, the SEC’s enforcement action “makes no mention of the common stock obtained through these equity lines of credit. Instead, the Commission appears to make an arbitrary decision that transactions involving convertible, variable rate notes should be subject to different – and harsher – regulatory treatment.”
Commissioner Uyeda questions whether the Supreme Court would have issue with the SEC’s interpretation in light of the recent striking down of the Chevron defense. In particular, “[S]ingling out of notes transactions as requiring dealer registration appears to be an arbitrary application of the “dealer” definition. This type of arbitrary implementation was a concern to the Supreme Court when it overturned the Chevron doctrine in Loper Bright Enterprises v. Raimondo. As Justice Gorsuch explained in his concurring opinion, “because the reasonable bureaucrat may change his mind year-to-year and election-to-election, the people can never know with certainty what new ‘interpretations’ might be used against them.” Actions like the one the Commission takes today invite heightened judicial scrutiny of the Commission’s interpretation of the term “dealer.””
Commissioner Uyeda succinctly wraps up his statement with “[T]he Commission’s actions also further raise questions as to whether its implementation of the “dealer” definition under the Exchange Act should be analyzed under the Supreme Court’s “void for vagueness” doctrine, which “addresses at least two connected but discrete due process concerns: first, that regulated parties should know what is required of them so they may act accordingly; second, precision and guidance are necessary so that those enforcing the law do not act in an arbitrary or discriminatory way.” Under the Commission’s current interpretation of the “dealer” definition, parties cannot know what is required of them, and the Commission’s lack of precision enables enforcement actions to be undertaken in an arbitrary and discriminatory manner.”
The Author
Laura Anthony, Esq.
Founding Partner
Anthony, Linder & Cacomanolis
A Corporate and Securities Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, 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, Linder & Cacomanolis, 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 ALC 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 the American Red Cross for Palm Beach and Martin Counties, 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.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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