Under current federal securities statutes, few categories of transactions permit free trading or unrestricted stock to be issued and immediately resold into the public market without the transaction being subjected to the expense and delay associated with the filing of a registration statement with the SEC. In recent years, enterprising investors have realized that the civil litigation process can be utilized to satisfy the “governmental entity” requirement of Section 3(a)(10) and that the use of the court process satisfies all of the other conditions of the exemption. This realization has breathed new life into the over-the-counter securities market, allowing stagnant debt obligations of public securities issuers to be exchanged for common stock that can be resold in the public market. In practice, creditors holding trade debt, delinquent promissory notes, and newly lent funds negotiate with company management for the exchange of the debt for deeply discounted common stock in a settlement that will be blessed by a court in a fairness hearing after a friendly civil complaint has been filed.

Section 3(a)(10) of the Securities Act of 1933, Staff Legal Bulletin No. 3A (2008), and Staff Legal Bulletin No. 3 (1999), collectively provide an exemption from securities registration and a procedure whereby a claim asserted against an issuer of securities may be settled with the issuance of its free-trading securities as payment. A governmental entity must determine that the transaction is fair to the claimant, among several other conditions. Legal Bulletin No. 3A notes that “the reviewing court or authorized governmental entity making the fairness determination ‘must have sufficient information before it to determine the value of both the securities, claims or interests to be surrendered and the securities to be issued in the proposed transaction.’”

With such modest and inexpensive barriers to obtaining free-trading stock, a gold rush of sorts has spawned to loan money or purchase payables from public companies and dump it on the markets for large profits. With this has come attempts by lenders to convert debt into seemingly endless supplies of cheap stock in death-spiral transactions that push stock prices to the lowest quotable price and with effective transaction prices occurring even lower.  Among these conversions of debt, three styles of 3(a)(10) transactions have developed: the make-whole transaction, the penalty-share transaction, and the free ride. Only one of these styles is likely to gain SEC acceptance, and the other styles are likely to be examined and civilly prosecuted for abuse of the exemption.

Nevertheless, SEC review of an exempt transaction for compliance with statutory requirements is relatively rare and is not automatic. Transaction compliance reviews can occur when a stock transfer agent is routinely examined by the SEC, when a stock sale has triggered a review at FINRA as its computers sift market data, when the SEC does a sweep examination for compliance with a certain statute or rule, or when someone complains to the SEC. Thus, SEC review is almost always after-the-fact.  However, a large volume of transactions are occurring in reliance on the Section 3(a)(10) so greater enforcement review in this area is likely.  In a compliance examination or enforcement inquiry, the SEC looks at both the company issuing stock as a medium of settlement payment and the recipient of the stock for compliance with the 3(a)(10) exemption because the exemption allows the stock that is issued to be re-sold without registration. If the exemption is blown, both parties may have participated in an unregistered transaction and may need to qualify for another exemption from registration or be in violation of the registration requirement imposed by Section 5 of the Securities Act of 1933, particularly if the stock issued in the purported 3(a)(10) transaction has been re-sold by the plaintiff. It is possible for just one party to violate the 3(a)(10) exemption while the recipient does not. Thus, the structure of the settlement and the manner in which the stock is solicited and re-sold play important roles in the SEC’s evaluation of potential abuse of the 3(a)(10) exemption.

In a recent settled administrative order, the SEC took action against a professional lender/seller of deeply discounted securities obtained in exchange for the settlement of creditor claims against the securities issuer. See, In the Matter of IBC Funds, LLC, SEC Admin. Proc. No. 3-17125 (Feb. 19, 2016), in which the SEC charged IBC Funds, LLC, with being an unregistered broker because it received discounted shares that it subsequently liquidated.  Certain industry participants may have concluded that the IBC Funds problem can be cured by having a licensed securities broker involved in the transaction because more parties are mandating inclusion of a broker as a conduit for the issuance of shares.  In all compliant 3(a)(10) transactions, the re-sales must be made through a licensed securities broker. This new spin on inclusion of the broker in the chain of the stock issuance seems to put a brokerage firm on the issuance side to the settling party. This does not cure the unregistered distribution problem but might serve to insulate the settling party from being deemed an unregistered securities broker in some situations.  In Part Two we will explore in greater depth the unregistered distribution problem.

We are well-familiar with Section 3(a)(10) transactions and can work with creditors and issuers to structure 3(a)(10) transactions that comply with the exemption.