SEC’s Dealer Crackdown Wins in Court, Alarming Investment Firms

The Securities and Exchange Commission is on a winning streak after cracking down on “toxic” lending using a relatively novel legal theory—one that has spooked investment firms leery of being tagged as a securities dealer.

The SEC in recent years has sued numerous people who got shares in penny stock companies at a discount by lending them money. District courts in places like New Jersey, Minnesota, and Florida have sided with the agency and found the lenders illegally acted as unregistered securities dealers.

The SEC’s latest win came last week when the US Court of Appeals for the Eleventh Circuit held Ibrahim Almagarby, a Florida man whose business model was predicated on quickly flipping the stocks, met the definition of a “dealer.”

The Feb. 14 ruling is the first endorsement from an appeals court in the SEC’s crackdown, with additional cases on the horizon, including in the pivotal Second Circuit covering New York.

But some investment firms worry the decision creates confusion about who counts as a securities dealer. The label can bring steep compliance costs for firms that have to register with the SEC and more oversight from the industry-backed Financial Industry Regulatory Authority.

“What we know in terms of where the line is, is that it’s not where we thought the line was 10 years ago,” said Marc Indeglia, president of the Small Public Company Coalition, which represents investors in the small and microcap markets. “There are a lot of people who may need to reconsider whether or not what they’re doing requires a license.”

‘Toxic’ Lending

The SEC’s cases have focused on lenders who obtain a type of convertible debt—or debt that can be exchanged for stock—known as “market adjustable securities” from penny stock companies.

Unlike other convertible debt, attorneys say market adjustable securities allow lenders to change the debt into stock at a percentage discount from the market price.

Some of Almagarby’s debt, for example, was convertible at a 50% discount from the market price, according to the Eleventh Circuit. Brenda Hamilton, a securities lawyer at Hamilton & Associates Law Group, P.A. in Boca Raton, Fla., said she’s seen discounts as high as 70%.

Investment firms and other lenders say they are providing much-needed capital to risky companies that can’t obtain financing from traditional sources, and that the discounts are a hedge.

But critics call the loans “toxic.” Once the debt is converted to shares, the lender can quickly sell the shares into the public market, which can cause share prices to plummet and send penny stock companies into a “death spiral,” critics say.

The loans, which have been around since at least the late 1990s, started to become more prevalent in the early 2010s, securities lawyers said.

The SEC sued Almagarby in late 2017 under the theory he violated federal securities law because he didn’t register as a securities dealer. The SEC said Almagarby, who started his business in 2013 as a 29-year-old college student, acquired and sold billions of shares of penny stocks, netting close to $900,000 in profits. A wave of similar cases followed.

They were “the Hiroshima bomb” on so-called toxic lenders, Mark Basile of the Basile Law Firm P.C. said.

Basile’s firm has represented companies suing their lenders for violations of state usury law, among other things. The theory that lenders violated federal securities laws was “another avenue to attack these guys,” he said.

SEC Wins

The SEC’s “dealer” theory is gaining traction in court.

Of the more than dozen civil cases the agency has brought alleging convertible note lenders acted as unregistered dealers, the SEC has won judgments in at least four, according to Bloomberg Law’s review. Several others have survived a motion to dismiss or settled.

Almagarby argued at the Eleventh Circuit that he didn’t have fair notice of the SEC’s “novel theory.” He also maintained he was a trader, exempt from dealer registration. The appeals court rejected both arguments.

The SEC’s cases are against “individuals who are selling billions of shares of stock of penny stock companies, usually in short periods of time,” Hamilton, the Boca Raton securities lawyer, said. “It’s different than the trader.”

But the agency’s arguments in such cases have raised concerns for investment advisers and private fund managers.

Industry groups including the Alternative Investment Management Association and Trading and Markets Project told the Eleventh Circuit they’re worried the SEC’s interpretation of a “dealer” could sweep in all sorts of financial firms. MFA, formerly known as the Managed Funds Association, filed a brief in another Eleventh Circuit case, arguing only people who execute orders for customers are dealers.

Private funds and proprietary trading firms are already grappling with rules the SEC adopted this month that could force dozens to register as dealers.

The Eleventh Circuit in Almagarby’s case took pains to differentiate his firm from institutional asset managers, saying the latter group doesn’t rely on the “rapid resale” of microcap shares for their income or use networks of finders to solicit microcap debtholders.

Still, the Eleventh Circuit acknowledged that drawing a line between dealers and traders was difficult. The decision creates “a significant amount of uncertainty” for small investors, hedge funds, and venture capital funds, Indeglia said, warning small businesses could lose access to a source of capital.

“If you don’t explain where the line is, how are people supposed to understand whether they’re breaking the law or not?” he said.

Bigger Targets

Almagarby was ordered by the appeals court to disgorge over $885,000 in profits, although it lifted the lower court’s penny-stock ban against him, in part because there was no fraud, the Eleventh Circuit said. Other defendants are at risk of losing much more financially.

Justin Keener, who is set to argue his case at the Eleventh Circuit in May, was alleged to have made $7.7 million in profits from an unregistered dealer business. In Chicago, the SEC is pursuing a case against John Fife and five of his companies, which are alleged to have made $61 million in profits.

Fife has argued in court filings the case against him is based on a “government bait-and-switch,” with a “new, made-for-litigation view” of what a dealer is. The district court denied his motion to dismiss in late 2021.

The SEC’s lawsuits to date have largely involved people and firms selling penny stocks traded in over-the-counter markets. Basile said he expects the SEC will next turn its attention to larger debt arrangements with small-cap companies listed on a major stock exchange.

“It’s just a matter of time and who they target,” Basile said.

Defendants’ legal arguments could be narrowing. The Eleventh Circuit’s decision in Almagarby, together with some previous, but related, cases in other circuit courts, have addressed the “arguments that the funders have been using to try to defeat these claims,” Basile said.

An open question is how the Second Circuit will address the “dealer” theory in these types of cases. The circuit court’s jurisdiction includes New York, where various lawsuits have been brought by the SEC and by companies.

“Once the Second Circuit decides this, it will shut the door completely on all these arguments,” Basile said.

The Almagarby case SEC v. Almagarby, 11th Cir., No. 21-13755.