With its decision in Securities and Exchange Commission v. Keener (May 29, 2024), the U.S. Court of Appeals for the Eleventh Circuit has now twice in the span of four months affirmed a broad interpretation of who is considered a “dealer” for purposes of the securities laws. More specifically, the Eleventh Circuit upheld the Securities and Exchange Commission’s (“SEC”) position that a person engaged in the business of purchasing—for its own account—convertible debt notes from microcap issuers (also referred to as “penny-stock” companies), converting the notes into common stock, and selling that stock in the market meets the definition of a “dealer” under the Securities Exchange Act of 1934 (the “Exchange Act”), and must therefore be registered as a dealer with the SEC. The decision in Keener closely tracked the same Court’s decision in Securities and Exchange Commission v. Almagarby, Microcap Equity Group (February 14, 2024), in which the Eleventh Circuit agreed with the SEC that the plaintiff Almagarby had been acting as an unregistered “dealer” in violation of the Exchange Act by obtaining convertible debt of microcap companies for his own account, converting the debt into common stock, and then selling the stock. 

At first glance, these two decisions may seem relatively narrow in applicability.  As the Eleventh Circuit noted in both opinions, the SEC enforcement actions in question were against individuals who had repeatedly engaged in patterns of “lending behavior—converting debt to stock at a significant discount and selling the resultant shares at high volumes—[] known as ‘toxic’ or ‘death spiral’ financing.” As an investor protection matter alone, the SEC has an interest in scrutinizing the market activities of such lenders. That said, the implications could reverberate beyond the microcap world in more ways than one. First, it is clear that the SEC has judicial support—from a conservative court, even—for its escalation in the enforcement arena of actions aimed at capturing a wider range of activity under the Exchange Act definition of “dealer.” As we discussed in a previous Client Alert, the SEC is aggressively expanding that definition in the rulemaking arena as well.  In February, it adopted two new final rules further defining the terms “dealer” and “government securities dealer” under the Exchange Act. These rules, which establish specific standards for what it means to engage in buying and selling securities “as part of a regular business,” have been widely interpreted as categorizing a broader array of market participants as “dealers” and—because of the qualitative nature of the new tests and lack of bright-line categories—giving the SEC more latitude in determining that certain activities amount to acting as a “dealer.” The rules are currently the subject of litigation in the U.S. District Court for the Northern District of Texas; it remains to be seen whether that court will determine that the SEC was within its authority to adopt the new, more expansive definitions. But the Eleventh Circuit’s support of the SEC’s enforcement position will stand regardless of the outcome of the rulemaking litigation, unless and until the Supreme Court considers the question.

Second, the Keener decision further solidifies the notion that a person may be considered a “dealer” for purposes of the Exchange Act regardless of whether such person is effectuating securities transactions for customers or is trading purely for his or her own account. Keener had argued that “market participants and Congress historically ‘presumed’ that dealers handled orders for customers” and that the phrase “for such person’s own account” as used in the Exchange Act definition of “dealer” is a “term of art presupposing that trades executed through a dealer’s account are for customers”—neither of which argument the Eleventh Circuit apparently found convincing. In Almagarby, and again in Keener, the Court explained that “a customer requirement has no grounding in the statutory text.”  The Court elaborated in Keener that the Exchange Act, in contrast to requiring dealers to have a customer-facing role, “defines dealers by their function, as being ‘in the business of buying and selling securities’” (emphasis in original). This statutory interpretation puts even more pressure on the Exchange Act definition’s exception for persons that buy or sell securities “but not as part of a regular business,” and the two new rules discussed above that seek to elaborate on what that phrase means. 

Third, with these two decisions, the Eleventh Circuit also seems to be supporting—or at least certainly not stopping—the trend towards more expansive regulation of non-bank market participants, such as private funds, proprietary trading firms, and alternative credit managers. Although Almagarby and Keener involved SEC actions against individuals engaged in “toxic lending” to microcap issuers, the cases may portend a broader interest in applying heightened (i.e., more bank-like) regulation to non-banks extending private credit, as well as active traders such as equities-focused hedge funds or insurance companies. In evaluating whether Keener’s activities constituted that of a “dealer” for Exchange Act purposes, the Eleventh Circuit found meaningful the facts that Keener’s request to convert into stock any of the issuer’s outstanding debt that he held would trigger the creation of new shares that did not previously exist in the market, and that subsequently Keener would sell the stock generally within six to nine months.[1] Although the facts in Almagarby and Keener are far afield from the typical investment strategies used by investors in convertible bonds of listed companies, there may be situations where such investors, as well as other private credit providers, receive shares in settlement of convertible debt shortly after the Rule 144 holding period expires. Managers of funds receiving debt in such situations—particularly if they do so regularly—may wish to consider whether these cases have bearing on their regulatory analysis under the “dealer” definition.

We continue to monitor developments on the rulemaking, enforcement, and judicial fronts with respect to the expansion of the “dealer” definition as well as policymakers’ interest in private credit activities more generally.

[1] The Court noted in Almagarby that the defendant effectively avoided being deemed to have acted as an underwriter by only purchasing convertible debt that was “old enough to be exempt from the registration requirements of the Securities Act of 1933 under the Commission’s Rule 144.  See 17 C.F.R. § 230.144 (providing that Rule 144 exemptions provide a ‘safe harbor’ from Securities Act registration requirements if the security is held for over six months or one year, depending on the exemption).”  By doing so, Almagarby was able to sell acquired shares into the market almost immediately upon conversion, as Rule 144 considers shares acquired in a conversion to have been held from the date on which the holder acquired the initial convertible instrument. 

Note that in late 2020, the SEC proposed an amendment to Rule 144 that would adjust the methodology for determining the “holding period” of market-adjustable securities issued by an issuer that is not publicly traded—as described in the Fact Sheet accompanying the proposal, the SEC recognized that this concept of “tacking” holding periods “creates an incentive to purchase the market-adjustable securities with a view to distribution of the underlying securities.”  Under the proposed amended rule, the holding period for the applicable underlying securities would not begin under the conversion date of the market-adjustable securities.  The proposal remains on the SEC’s agenda.