FINRA Lawyer Blog
What is a securities dealer? The answer is more complicated than people might think. On August 2, 2022, the SEC announced that it had reached a settlement with a Long Island firm, Crown Bridge Partners, LLC (“Crown Bridge”) and the two brothers who owned the firm Soheil and Sepas Ahdoot, for failing to register as a dealer. As part of the settlement, the Defendants agree to pay disgorgement and prejudgment interest of $8,390,601.27 and a civil penalty of $810,307, and to a five-year penny stock bar.
According to the SEC’s complaint, Crown Bridge purchased approximately 250 convertible notes from approximately 150 penny stock issuers. In all, during the Relevant Period, Crown Bridge sold into the public markets approximately 35 billion shares of unrestricted, post-conversion shares of penny stock issuers, for millions of dollars in profits. Soheil and Sepas initially found companies interested in issuing convertible notes by reviewing OTCMarkets.com, a website that includes a news feed of SEC filings and press releases from penny stock issuers. They used the website to identify issuers that appeared to need or had expressed a need for financing. They then cold called the issuers directly. Over time, as Crown Bridge grew its business and became known in the industry, issuers, brokers, and finders reached out directly to Soheil and Sepas to seek funding.
Absent their apparent failure to register Crown Bridge as a Dealer under Exchange Act Section 15(a) [15 U.S.C.§ 78o(a)], Soheil and Sepas executed what appears to have been a very shrewd and successful business plan. Crown Bridge purchased convertible notes directly from penny stock issuers. They negotiated the terms of the notes that led to millions of dollars in profits when the notes were converted into shares of stock. The notes typically contained terms that were highly favorable to Crown Bridge and reduced Crown Bridge’s exposure to market risk such as a conversion discount ranging from 25% to 50% to the prevailing “market price,” a term the notes typically defined as the lowest trading price, or lowest closing bid price, of the issuer’s common stock during the 10 to 25 days on or before the date of the conversion notice. Also critical was Crown Bridge’s right to convert the notes in increments, enabling Crown Bridge to convert what it could sell immediately, while shielding the remaining balance from exposure to market price movements.
Crown Bridge typically held the notes for six months, or until such time as it could claim the SEC Rule 144 exemption from registration [17 C.F.R. § 230.144]. SEC Rule 144 allows non-affiliates who acquire restricted stock directly from the issuer in a private transaction to resell it free of restriction into the market after observing a holding period, among other requirements.
The SEC’s complaint very specifically points out that Crown Bridge converted the notes with an eye toward distributing the underlying shares into the public markets for a profit based on the spread between the market price and the discounted acquisition price, as opposed to holding the shares for appreciation. The SEC noted that, “[t]his limited exposure to market risk is a common attribute of a securities dealer. It derived those profits principally from the discounted acquisition price, not from appreciation in the market price of the issuer’s common stock.” The SEC also stated that, “[t]his limited exposure to market risk is a common attribute of a securities dealer.”
Section 3(a)(5) of the 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 . . . .” The SEC’s website states, that “[t]raders are excluded from the definition of a dealer” because while they may buy and sell securities for their own account, the do so “not as part of a regular business.” So what does it mean to be “in the business” of buying and selling securities versus being a common investor? What if a substantial part of someone’s income comes from day trading? Does it matter, as noted above, that the profits derived by Crown Bridge were not from appreciation in the price of the stock? What if Crown Bridge held the securities for longer and were exposed to more market risk but still made a profit from the discounted acquisition price?
The SEC’s “Guide to Broker-Dealer Registration” provides the following guidance regarding whether someone is a dealer:
- a person who holds himself out as being willing to buy and sell a particular security on a continuous basis;
- a person who runs a matched book of repurchase agreements; or
- a person who issues or originates securities that he also buys and sells.
Here are some of the questions you should ask to determine whether you are acting as a dealer:
- Do you advertise or otherwise let others know that you are in the business of buying and selling securities?
- Do you do business with the public (either retail or institutional)?
- Do you make a market in, or quote prices for both purchases and sales of, one or more securities?
- Do you participate in a “selling group” or otherwise underwrite securities?
- Do you provide services to investors, such as handling money and securities, extending credit, or giving investment advice?
- Do you write derivatives contracts that are securities?
It seems that the brothers Ahdoot could credibly answer “no” to all of these questions and also state that the first three bullet points do not describe their business model. Yet, the SEC deemed them to be dealers rather than traders based almost solely on the fact that they had limited exposure market fluctuations.
The SEC seems to understand that there is some ambiguity in the current statutory definition of dealer. In March 2022, the SEC has proposed a new rule that further defines the phrase “as part of a regular business” as used in the definition. The new rule is primarily aimed at market participants who are not registered dealers and yet “engage in a routine pattern of buying and selling securities for their own account that has the effect of providing liquidity.” With the sale of 35 billion shares in the market over four years, it certainly seems that Crown Bridge squarely falls under the definition of a dealer if regularity of trading and having the effect of providing market liquidity are the key factors.
Herskovits PLLC has a nationwide practice defending against SEC investigations and litigation. Feel free to call us for a consultation. (212) 897-5410.