SEC Charges Firm for Unlawfully Engaging in Convertible Notes Business
Commentary by Steven Lofchie
The SEC charged an individual and his business ("defendants") for failing to register as a dealer in connection with a "convertible notes business."
In a Complaint filed with the U.S. District Court for the District of New Jersey, the SEC asserted that the defendants (i) entered into convertible notes with penny stock issuers or purchased convertible notes or shares already converted from such notes from unaffiliated third parties, (ii) converted the notes into shares of stock at large discounts from market prices and (iii) sold those newly issued shares into the public market at a significant profit. The SEC alleged that the defendants obtained convertible notes (or shares already converted from such notes) with respect to at least 31 separate issuers, and with respect to at least 25 of those issuers, the defendants sold at least $10 billion shares of penny stock into the market, for more than $18 million in gross sales. The SEC claimed the defendants were not registered with the SEC, and the individual was not associated with a registered broker-dealer. The SEC charged that, by failing to comply with the dealer registration requirements, the defendants avoided regulatory obligations for dealers that govern their conduct in the marketplace.
The SEC charged the defendants with violating ("and, unless enjoined, are reasonably likely to continue to violate") Exchange Act Section 15(a)(1) ("Registration and regulation of brokers and dealers").
The SEC requested, among other relief, that the Court (i) enjoin the defendants from committing further violations of the Federal securities laws as alleged; (ii) order the defendants to pay disgorgement, with prejudgment interest on a joint and several basis; (iii) order the defendants to pay civil monetary penalties; (iv) bar the defendants from participating in any offering of a penny stock, or inducing or attempting to induce the purchase or sale of any penny stock; and (iv) order the Defendants to (a) surrender for cancellation any shares the business obtained through conversion of notes or execution of warrants, (b) surrender any conversion rights under any remaining convertible notes, (c) surrender for cancellation any unexercised warrants that were obtained in conjunction with convertible notes, and (d) provide proof of same to the SEC.
Commentary
This is one of a series of actions that the SEC has brought against entities that (i) purchase convertible debt from penny stock companies, (ii) convert the debt into equity at a significant discount from the "market price" of the stock (after a holding period) and (iii) sell the debt to presumably unsophisticated individual investors. (See also Convertible Note Dealers Settle SEC Charges for Registration Violations; SEC Charges Firm Buying and Selling Convertible Notes with BD Registration Failures.)
Some in the industry have viewed these cases as controversial and as somehow providing support for - or related to - the SEC's recent expansion of the definition of securities dealer. It seems pretty clear, however, that the entities purchasing convertible notes, changing them into equities and flipping them to the retail public are engaged in an activity that is intended to be capital raising for the issuer by means that do not provide appropriate disclosure to retail investors and on terms that are likely extremely unfavorable to them.
The circumstances giving rise to the SEC's enforcement action in these cases simply have no relationship to the trading activities that the SEC now asserts require dealer registration. The SEC is acting wholly appropriately in bringing these enforcement actions, which do not serve as any basis of support for the SEC's conduct in its expansion of the dealer definition.