SEC sues convertible debt lender for alleged registration violation

Key Notes:

  • The SEC says a New Jersey convertible debt lender is a “securities dealer” who must be registered.
  • The case has broad possible implications for the convertible debt industry.
  • Lenders who meet the definition of a broker and who do not register may be subject to enforcement action and penalties.

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

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

Although the Exchange Act does not specifically define “carrying on a commercial activity” in securities transactions, a general understanding of this term which has evolved through case law and administrative action includes “lawfulness of participation”.[1] That is, a broker (requiring registration with the SEC) is one whose securities business is “part of a regular business”.[2] 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 stock broker. Those who buy convertible notes from public company issuers have traditionally taken the position that they are dedicated to offering junior debt securities to small-cap public companies, rather than buying and selling the securities. . This lawsuit should prompt convertible debt lenders to reassess their position and determine, in consultation with an attorney, whether they are required to register with the SEC as securities dealers.

Registration requires a broker to provide the SEC with important business information – some of which is made public – including the names of its direct and indirect owners and officers, details of certain agreements with other people or entities, l ” identity of those who control the business, the states in which it operates, past criminal or regulatory actions of the dealer or any affiliate that controls the business, and financial information, including history of bankruptcies. In addition, registered dealers are subject to filing requirements and oversight by FINRA or another self-regulatory body. They are also required to adopt and adhere to certain compliance procedures and to submit information on personnel and key representatives and past violations.

Lawsuit with the SEC

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

According to the SEC complaint, the vast majority of JDF’s earnings resulted from the discounted prices at which it acquired shares of issuers to sell them in the market, rather than interest and fees on promissory notes. The SEC also maintains that JDF retained the active advisory services of a person the SEC had previously prohibited from partnering with brokers.

The lawsuit, filed in New Jersey federal court, alleges that between 2015 and 2017, JDF engaged in the purchase of convertible notes from issuers of penny shares, the conversion of the notes into shares at a price much lower than the market price and the sale of the latter. newly issued shares on the market with significant profit. JDF reportedly bought convertible notes from more than 20 separate issuers and sold over 6.5 billion newly issued penny stocks on the market, generating more than $ 2.3 million in profits.

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

As alleged, at the time of this conduct, neither JDF nor its principal were registered with the SEC as brokers, in violation of the mandatory registration provisions of federal securities laws. By not registering, JDF has avoided certain regulatory obligations that govern the conduct of dealers in the marketplace, including submitting to regulatory inspections and oversight, complying with financial reporting requirements, and keeping books and records. registers.

The SEC accuses JDF of violating the registration provision of Section 15 (a) (1) of the Exchange Act, and charges the principal as a supervisory person under Section 20 (a ) of the Exchange Act.

Review registration requirements

While it is conceivable that this lawsuit would be specific to the circumstances of this case, particularly the fact that JDF partnered with a consultant that the SEC had previously banned from being associated with a broker and the sheer volume of In JDF’s trading, this case may also reflect a substantial shift in the SEC’s perspective on convertible lenders, with broad implications for the convertible debt industry. That remains to be seen pending further guidance from the SEC.

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

In his Broker Registration Guide, the SEC asks the following questions to help you determine if you are acting as a broker:

  • Do you advertise or let others know that you are in the business of buying and selling securities?
  • Do you deal with the public (retail or institutional)?
  • Do you market or quote prices for purchases and sales of one or more securities?
  • Do you participate in a “sell group” or otherwise buy securities?
  • Do you provide investor services, such as money and securities management, credit granting or investment advice?
  • Do you write derivative contracts that are securities?

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

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