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On February 26, 2020, for the first time, the Securities and Exchange Commission (SEC) sued a convertible debt lender and its principal, asserting that the lender meets the legal definition of a “securities dealer” and is therefore required to register with the SEC as a dealer. The SEC seeks permanent injunctions, disgorgement of ill-gotten gains, and prejudgment interest and civil penalties.

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Section 3(a)(5)(A) of the Securities Exchange Act of 1934 (Exchange Act) generally defines a “dealer” as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”

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While the Exchange Act does not specifically define “engaged in the business” of securities transactions, a general understanding of this phrase that has evolved through case law and administrative action includes “regularity of participation.”<a title="" href="#_edn1" name="_ednref1">[1]</a> That is, a dealer (requiring SEC registration) is one whose securities activities are “part of a regular business.”<a title="" href="#_edn2" name="_ednref2">[2]</a> This is a fact-based determination.

This appears to be the first time the SEC has sued a convertible debt lender for failing to register as a securities dealer. Those purchasing convertible notes from public company issuers have traditionally taken the position that they are in the business of providing junior debt to small-cap public companies, rather than the business of buying and selling securities. This lawsuit should prompt convertible debt lenders to reevaluate their position and determine, in consultation with counsel, whether they are required to register with the SEC as securities dealers.

Registration requires a dealer to provide important business information to the SEC – some of which is made public – including the names of its direct and indirect owners and executive officers, details about certain arrangements with other persons or entities, the identities of those who control the business, the states in which it does business, past criminal or regulatory actions of the dealer or any affiliate that controls the business, and financial information, including bankruptcy history. Further, registered broker-dealers are subject to filing requirements and the oversight of FINRA or another self-regulatory organization. They also are required to adopt and adhere to certain compliance procedures and to submit disclosures about key personnel and representatives and past violations.

JDF Capital, Inc. (JDF) is a New Jersey-based convertible debt lender that buys convertible notes, a form of short-term debt, from small-cap public companies in need of capital. After holding the notes for approximately six months, JDF converts them into newly issued shares of stock at (previously negotiated) discounted prices and – pursuant to SEC Rule 144 – sells that stock into the market at a profit.

According to the SEC’s complaint, the vast majority of JDF’s profits resulted from the discounted prices at which it acquired shares from the issuers to sell into the market, rather than from the promissory notes’ interest and fees. The SEC also maintains that JDF retained the active consulting services of an individual whom the SEC had previously barred from associating with broker-dealers.

The complaint, filed in New Jersey federal court, alleges that between 2015 and 2017, JDF engaged in the business of purchasing convertible notes from penny stock issuers, converting the notes into shares of stock at a large discount from the market price, and selling those newly issued shares into the market at a significant profit. JDF allegedly purchased convertible notes from more than 20 separate issuers and sold more than 6.5 billion shares of newly issued penny stock into the market, generating over $2.3 million in profits.

The complaint highlights that the vast majority of JDF’s profits resulted from its stock trading operations, rather than from interest on promissory notes. This mechanism, which gave JDF a spread (or markup) on the stock it sold, is a common attribute of a securities dealer.

As alleged, at the time of this conduct, neither JDF nor its principal were registered with the SEC as dealers, in violation of the mandatory registration provisions of the federal securities laws. By failing to register, JDF avoided certain regulatory obligations that govern dealers’ conduct in the marketplace, including submitting to regulatory inspections and oversight, complying with financial reporting requirements, and maintaining books and records.

The SEC is charging JDF with violating the registration provision of Section 15(a)(1) of the Exchange Act, and it is charging the principal as a control person under Section 20(a) of the Exchange Act.

While it is conceivable that this lawsuit is specific to this case’s circumstances, particularly the fact that JDF associated with a consultant whom the SEC previously barred from being associated with a dealer and the sheer volume of JDF’s securities trading, this case may also reflect a more substantive shift in the SEC’s view of convertible lenders, with broad implications for the convertible debt industry. This remains to be seen pending further SEC guidance.

In light of this lawsuit, convertible debt lenders should take heed and examine, in consultation with counsel, whether they are required to register with the SEC.

In its <a href="https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html#II" target="_blank" rel="noopener">Guide to Broker-Dealer Registration</a>, the SEC provides the following questions to help determine whether you are acting as a dealer:

A “yes” answer to any of these questions indicates that you may need to register as a dealer.

Cassandra W. Borchers 513.352.6632 <a href="mailto:Cassandra.Borchers@ThompsonHine.com">Cassandra.Borchers@ThompsonHine.com</a>

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions.

<a title="" href="#_ednref1" name="_edn1">[1]</a> <a href="https://law.justia.com/cases/federal/district-courts/FSupp/411/411/1643283/" target="_blank" rel="noopener">Massachusetts Fin. Servs., Inc. v. Securities Investor Protection Corp., 411 F. Supp. 411, 415</a> (D. Mass.), aff’d, 545 F.2d 754 (1st Cir. 1976), cert. denied, 431 U.S. 904 (1977); see also II L. LOSS, SECURITIES REGULATION 1295 (1961) (Professor Loss suggesting that the phrase “engaged in the business” “connotes a certain regularity of participation in purchasing and selling activities rather than a few isolated transactions.”).

<a title="" name="_edn2" href="#_ednref2">[2]</a> Exchange Act § 3(a)(5).

https://admin.thompsonhine.com/wp-content/uploads/2022/05/Investment_Management_Update_-_SEC_Sues_Convertible_Debt_Lender_for_Alleged_Registration_Violation.pdf

SEC Sues Convertible Debt Lender for Alleged Registration Violation

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