Over the past 15 years, we’ve paid particular attention to OTC issuers in this blog. We’ve followed them from the high-profile stock promotions days, which made millions for company insiders and savvy traders in the early 2010s to the nightmare of the SEC’s amended Rule 15c2-11, which was aimed at eliminating shell companies and shutting down pump-and-dump schemes that defined the penny stock market in the 2010s and early 2020s.
Only 10 years ago, the OTC was full of shell peddlers. Some of them had obtained dozens of these companies, which they’d then “clean up” and sell. Many were eventually used in pump-and-dump operations. When compliance with the new Rule 15c2-11 became mandatory in late September 2021, nearly 3,000 issuers were transitioned to OTC Markets’ “Expert Market,” formerly known as the “Grey Market.”
At the same time, the Commission decided to address a problem that had plagued the world of penny stocks since the 1990s, but had never been previously addressed. That problem was related to the most popular type of financing available in the world of penny stocks — market-adjustable, convertible notes.
Most OTC paper is not what anyone would call “investment quality,” and the companies are unlikely to find conventional, conservative lenders like banks. They are, of course, free to offer stock to accredited investors in private placements, but while launching an offering is easy, selling all of it and so realizing your financial goal can be very difficult.
However, there is an easy way for a CEO to raise the cash they need. It’s cynically referred to as “toxic lending” or “death spiral financing.” The lenders offer relatively short-term loans, sometimes calling them private placements. The borrower will receive cash; the lender will be issued a promissory note, preferred stock, or a debenture. Whatever the nature of the instrument, it will be convertible to the company’s common stock. A special feature of these deals is the method by which the amount of stock the issuer will receive is determined. The amount will be “market adjustable.” That is, the conversion price will be determined by the price of the issuer’s stock.
The conversion price will not be the stock’s current price. One of the perks a toxic funder is entitled to is a discount to the market price that will be applied to the amount of stock he receives when he decides to convert his note and sell the resulting common stock. The issuer will get an initial break: pursuant to Rule 144, there will be a holding period during which the lender cannot convert and sell. It will be six months for a company that’s an SEC filer, or one year for a non-filer.
When that holding period expires, the lender will be free to convert immediately, at the discount described in the stock purchase agreement he and the company signed. Usually, the discount is 40 to 50 percent; however, under certain circumstances — such as if the issuer has committed several of the “default events” specified in the agreement — it may be as high as 60 to 70 percent. The price at which he’ll convert, called the “reference price,” is fixed by averaging the stock’s two or three lowest closing bid prices of the preceding month. (Obviously, if they wished, the parties could agree on just one bid price, or more than three, calculated for a somewhat longer period.) The discount will be applied to the reference price.
Once the note is converted, the lender will almost always quickly sell the stock he received. He’ll probably not convert his entire position because the more stock he tries to dump on the market, the harder it will be. Sometimes he’ll hire a promoter to generate enthusiasm and prevent the stock from tanking too badly. But the stock price will decline. And because the exchange rate the lender gets is market-adjustable, the next time he converts, he’ll receive more stock for his money than he did on the first round. When he’s finished, if he still has a portion of his note remaining, he can hold it for a while, hoping the price will appreciate, or dump and move on.
To make matters worse, some issuers find themselves so badly pressed for funds that they become involved with more than one toxic funder at the same time, accelerating the decline in the stock price and increase in the number of shares outstanding. The more loans that are arranged, the greater the dilution suffered by the stock.
Ultimately, the only viable option for management is a reverse split. Sometimes the pattern repeats, and eventually the stock may be moved to the Expert Market. Once upon a time, it might then be sold as a shell and stripped of most of its shares outstanding. That is harder now, thanks to the amended Rule 15c2-11.
What the SEC did to the Toxic Lenders
By the mid-2010s, there was a nearly universal understanding of toxic financing. It was known to be irredeemably bad, with one exception: if the issuer traded OTC, and had scheduled a reverse split to raise its stock price to a level high enough to accommodate its listing on a national stock exchange. The Commission needed to add a new tool to its arsenal, designed to address lenders whose business consisted mainly of almost riskless “investments.” In rare circumstances, they might end up holding more stock than they were able to sell into the market, but on balance, they made out like bandits.
Then the SEC had an idea: it would show in court that specific toxic funders were not only making pots of money, but they were also engaging in a type of work that violated the definition of a “dealer” as it had been developed by the SEC. The definition had evolved over the years, as questions arose about how to distinguish between individual investors who traded for their own accounts and professionals buying and selling stocks as part of their business. That interpretation of what a “dealer” is was included in a 2008 SEC publication called “Guide to Broker-Dealer Registration.”
The Guide addressed the question of who, technically, is a “broker,” a “dealer,” or a “broker-dealer.” It also provided information on what the reader should do if they believed they might qualify as a member of one of those categories. If a real problem is identified, the individual or entity will be encouraged to register with the SEC and join FINRA.
The Guide still identifies a dealer as “any person engaged in the business of buying or selling securities for his own account, through a broker or otherwise.” That phrase has alarmed some people who don’t consider themselves market professionals, but rather administrators of their own finances, who may or may not rely on a broker-dealer for assistance. Did they need to tell the SEC about it?
The Guide assures them that it won’t be necessary, thanks to what’s come to be called the “trader exception”:
The definition of “dealer” does not include a “trader,” that is, a person who buys and sells securities for his or her own account, either individually or in a fiduciary capacity, but not as part of a regular business. Individuals who buy and sell securities for themselves generally are considered traders and not dealers.
Obviously, it’s easy to see that firms like commercial brokerages need to register with the SEC, but there are cases that may be less clear. According to the Commission, you may need to register if, in addition to trading as part of a “regular business,” you’re willing to buy and sell specific securities on a continuous basis, issue securities, or advertise to the public that you buy and sell securities. (Some “unregistered dealers” hire promoters or even create their own boiler rooms and use them to make it easier to sell the massive amounts of stock generated by their periodic conversions.)
Having given the matter some thought, the Commission believed it could use its “dealer” definition to help rid the markets of toxic lenders. It brought its first case in November 2017, against a young man called Ibrahim Almagarby and his firm, Microcap Equity Group LLC. Almagarby started his lending business while he was in college, as he needed money. He, like the equally young Joshua Sason, found he’d hit upon a very lucrative side hustle. Other practitioners, such as wealthy Chicagoan John Fife and his onetime partner Justin Keener, had found their specialty in the 2000s; Kurt and Seth Kramer were also successful and established toxic funders.
The SEC has sued all of them, as well as several others — the total number is around 20 — since introducing its “unregistered dealer” concept in SEC v. Almagarby. Most of the early cases, including Almagarby, were appealed. Those that appeared in appellate courts attracted followers who, for the most part, represent conservative or libertarian groups. They firmly believe that minimal regulation is most likely to encourage strong and free markets. Several of these entities have attempted to influence court outcomes by appearing as amici curiae, but they have had very little success. Judges seemed willing to support the SEC’s arguments for keeping a tight leash on the would-be funders.
The New Rule
By 2021, when compliance with the SEC’s amendments to Rule 15c2-11 became mandatory, efforts to curtail the activities of the toxic lenders had, at least to outside observers, been moving along nicely. To tie up any loose ends, the Commission decided to make its new definition of “dealer” official. On March 28, 2022, a proposed rule, called “Further Definition of ‘As a Part of a Regular Business’ in the Definition of Dealer and Government Securities Dealer,” was introduced to the public for consideration. The comment period would close on May 27.
What is new in the proposal is found on pages 190 through 194. Many SEC rules are far longer, but in this case, the length seems unnecessary, and the reasoning behind it labored. Because the definition supplied in the proposed rule is so brief, many commenters believed it was insufficient. For example, Jennifer Han of the Managed Funds Association noted that:
In several recent enforcement actions, the Commission has argued novel and expansive theories regarding the meaning of the Exchange Act term “dealer”. We are concerned that the Commission is taking the position that the definition of “dealer” is so broad it would encompass virtually every financial firm in the world, including mutual funds, private funds, and pensions.
Han’s concerns were not hers alone. Stephen John Berger of Citadel was concerned about the implications of the new definition for the bond markets:
The Commission has failed to articulate any rational basis for requiring private funds and their advisers to register not only as investment advisers but also as dealers. In practice, it is unworkable to subject those who invest in the Treasury market as customers to an extremely burdensome regulatory framework designed specifically for dealer firms that facilitate customer trading, meaning that the most likely course of action for these customers would be to reduce the volume of their investment, trading, and hedging activities below the proposed threshold, or to materially withdraw from the market.
The SEC naturally did not expect any of that to happen, but the possibility needed only to exist. The comment letters were generally unfavorable. That is usually the case, though this time the disagreements among the Commissioners were especially strong. Nearly all the commenters believed the new rule was so vague that it would affect many types of investors it was not intended to affect. Even the SEC itself said it had identified “up to” 43 firms that might be required to register. Several law firms commenting said they believed the number would be much higher.
Commissioner Hester Peirce wrote a comment disagreeing with nearly every aspect of the new rule. She was particularly concerned with a liquidity provision:
Although the Commission and its staff have previously stated that liquidity provision may be indicative of dealing activity, it has not to my knowledge ever before stated categorically that liquidity provision alone by a person trading for its own account constitutes dealing activity or that trading activity becomes dealing activity merely because it has the effect of providing liquidity.
She was not alone in her concern. Mark Uyeda, her fellow Republican Commissioner, wrote a strong response, pointing out, as had others, that “today’s action may reduce liquidity in the Treasury markets, make them more volatile, reduce the number of liquidity providers, and increase debt costs to taxpayers.” He then added acidly:
Prior 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 SEC ’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 SEC, and on which a court has never ruled.
A few minor changes were made, but the rule was adopted on February 6, 2024, with the votes of Chairman Gensler and Commissioners Crenshaw and Lizárraga. But the matter had not ended. This new “Dealer Rule,” as some called it, was winning lawsuits against toxic lenders for the SEC, but it was also worrying the bond and crypto markets.
The “Dealer Rule” Sinks Without a Trace
The November 2024 election went badly for the Democrats. While historically the SEC hasn’t been a wildly political part of the federal government, it does have its moments, and this is one of them. Crypto and all things DeFi are Republican favorites. Hester Peirce, known to some as “Crypto Mom,” has been waiting to do transformational things with crypto, and her time is finally here. One of Mark Uyeda’s first moves as Acting Chairman was to name her to run the new Crypto Task Force. Peirce will, Uyeda says, “lead regulatory policy on crypto.”
Perhaps ironically, crypto enthusiasts played a considerable role in the end of the Dealer Rule. Once the Rule had been adopted, a chain of events was put in place. It resulted in two Texas lawsuits: National Association of Private Fund Managers; Alternative Investment Management Association, Limited; and Managed Funds Association v. Securities and Exchange Commission; and Crypto Freedom Alliance of Texas, et. al. v. Securities and Exchange Commission. They were heard by the same Federal District Court Judge, Reed O’Connor.
Judge O’Connor did not like anything about the Dealer Rule:
As now defined, many of the world’s most prominent market participants, including the Federal Reserve, may have been operating unlawfully as unregistered securities “dealers” for 90 years without anyone—including the Commission—having previously noticed. Operating as an unregistered dealer under the Exchange Act is a felony.
He moves on to what has perhaps always been the critical part of the argument against the Rule: that it makes anyone who “provides liquidity” to a market, a dealer. O’Connor is unimpressed by the “trader exception”. He’s read what Peirce wrote in her own criticism of the Rule, and agrees with her:
As Commissioner Peirce put it, “[t]his rule turns traders, many of whom are customers, into dealers. Doing so runs counter to the statute, as the Commission and market participants have read it for decades.” The Court agrees with Commissioner Peirce.
His chief point is that the Exchange Act has been in existence for 90 years, and what is described in it has been understood in a specific way for all those years. Why change the meaning of “dealer” now? That’s a serious question. After all, if the meaning of “dealer” is subject to change, why isn’t the same true of any other word in the Act? He believes further that “dealer and broker are sister-terms which must be read consistently. The Dealer Rule fundamentally upsets the balance between these terms.”
It should be noted that the two cases O’Connor heard had nothing to do with toxic lenders. They were cases about the Dealer Rule, and why it should be struck down. In the end, he concluded that:
Because the Court decides that the SEC promulgated the Rule in excess of its authority—rather than merely failing to justify its decision for “an otherwise permissible rule”—remand would not be appropriate. The SEC would not be able to substantiate its novel definition on remand because there is no possibility that it could correct the fundamental lack of authority.
The result is the same in both cases. The SEC had the option of appealing the judgment and initially decided to do that just before Gary Gensler’s last day in the office. Paul Atkins, the new chair of the agency, wasn’t immediately confirmed. Mark Uyeda was named Acting Chair, and on February 19, 2025, he dismissed the appeal.
Crenshaw’s Last Stand
Caroline Crenshaw is the last remaining Democrat on the Commission. Gary Gensler said goodbye in January. Her colleague, Jaime Lizárraga, left around the same time; it seems no one has been named to replace him. It’s unclear how much longer Crenshaw can or will remain; for now, it seems nothing has been decided.
She seems discouraged. On May 22, she published a statement at the SEC site titled ‘Tis the Season for Dismissals: Statement on Ending “Dealer Lawsuits”.’
In it, she first laments the “abandonment” of crypto lawsuits. And…
Now the dismissals of “dealer” lawsuits. What do these unprecedented dismissals of ongoing enforcement actions have in common? They ignore the laws enacted by Congress – namely fundamental registration requirements of the federal securities laws – as well as long lines of judicial precedent. And they harm investors, businesses, and the capital markets.
It is astonishing that an agency tasked with enforcing the law has decided the law does not matter.
She is most certainly correct about all of that. But she isn’t correct to defend the “Dealer Rule” as if it were flawless. Flaws have been found, and they can’t be wished away. The problem is that the rule itself never addressed, or even pretended to address, the real problem, which is the existence of toxic financiers who offer small, desperate companies loans that, with enough time, will bankrupt those companies.
The lawsuits Crenshaw refers to most certainly show toxic funders at work. And this is correct as well:
The allegations in these now-dismissed lawsuits were not a stretch. They concerned well-established businesses that made money by purchasing debt directly from small issuers and then converting that debt into stock they would sell on the open market at high volumes and frequencies. The defendants in those lawsuits transacted in billions of shares of newly issued stocks for their own accounts, generating millions in profits. They had sophisticated marketing operations to maintain a pipeline of deals. That sure sounds like being in the regular business of buying and selling securities.
Yes, and the suits make, describe, and defend allegations of violations of the Rule. But we would contend no one merely reading about the Dealer Rule would guess that, or would have any idea at all what evil the rule prevents:
The final rules, Exchange Act Rules 3a5-4 and 3a44-2, further define the phrase “as a part of a regular business” in Sections 3(a)(5) and 3(a)(44) of the Securities Exchange Act of 1934 to identify certain activities that would cause persons engaging in such activities to be “dealers” or “government securities dealers” and be subject to the registration requirements of Sections 15 and 15C of the Act, respectively, in connection with certain liquidity-providing roles.
Who’s likely to imagine it’s all about loans, massive dilution, investor losses, and worse?
Crenshaw goes on to argue that the lawsuits were valid enforcement actions, fundamentally sound. They were. But unfortunately, the “novel” interpretation of the word “dealer” was just somebody’s clever idea about how to bring some sleazy lenders to justice. And it worked, until it encountered Judge Reed O’Connor. Perhaps he could see more clearly because the cases he dealt with were unrelated to honest or dishonest lending practices.
Now, alas, it is time for the death spiral funders to get their motors running. There’ll soon be plenty of money to be made.
To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at info@securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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