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Transfer Agents and a new Standard for Rule 144 Opinion Letters

Updated: Nov 16, 2021

Transfer agents require convertible note holders to supply a legal opinion letter from a securities attorney explaining the legal basis for issuing stock without a restriction .Shares acquired from conversion of a convertible note can be issued without a restrictive legend because the Rule 144 six months holding period for the Notes can be tacked to the holding period for the stock under Rule 144(d)(3)(ii), but only if the “conversion” is a mere exchange “of other securities of the same Issuer.” In short, tacking can ONLY apply if the notes are securities. In the past, it was sufficient for a convertible noteholder to ask an attorney to regurgitate a set of loose facts and slap a signature on a bare bones letter stating that the notes are securities exempted from registration under Rule 144. Opinion letters needed only to state that the shares were issues in connection with the conversion of convertible note, that the acquisition date of the note reflecting a six month holding period, and a representation that the Seller is not an affiliate, officer, director or beneficial shareholder, among other securities requirements. Now, transfer agents are coming under enormous scrutiny, as issuers’ securities attorneys begin to clap back and bring to light that holders of restricted securities, especially those acquired through conversion of convertible notes, need to set forth a “reasonable basis for an exemption”. Specifically, the noteholders need to show that the original contract establishing rights to the stock was itself a security, allowing the holding period to tack back to the original date of the note,not the time of conversion. Transfer agents rely on attorneys to set forth the foundation that the underlying note was a security in making the determination of whether or not the tacking period is applicable to satisfy the 180 day holding period necessary for stock to be issued without a restrictive legend. If convertible notes and lines of credit on which the tacking is based in the opinion letters are determined not to be securities under the Reves Test, issuances and sales of stock are not afforded Rule 144 exemptions and cannot be issued without a restrictive legend, without being in violation of securities laws. Securities violations resulting from an improper analysis of whether the note is a security can create tremendous jeopardy for transfer agents. It is only in light of recent court decisions that the opinion letter is required to state the grounds upon which the notes are characterized as securities. This begins with a Reves Test analysis. The US Supreme Court in Reves said that although a note is presumed to be a security, that presumption is rebuttable. Reves v. Ernst & Young, 494 U.S. 56 (1990). “Not every note or debt obligation is a security” Id at 468. The Supreme Court’s decision in Reves governs the analysis. Any note with a term of more than nine months is “presumed” to be a security unless it resembles one of the judicially enumerated instruments that are not securities, such as a note delivered in connection with consumer finance or a mortgage. In Reves, the Court set the analytic framework for determining whether a note bears a resemblance to one of the enumerated instruments or if it should be held to be a security. An opinion letter should address the four Reves factors in consideration of whether a note is a security: (i) whether the seller’s purpose is to raise money for general use of business or to finance substantial investments, and the buyer is motivated by the profit to begenerated, in contrast to a note to facilitate a minor purchase or sale or to correct for cash-flowdifficulties; (ii) whether the note involves an individual transaction or common trading for speculation orinvestment; (iii) whether there is a reasonable public expectation that the note would be viewed as security;and

(iv) whether another regulatory scheme applies that would reduce risk of the instrument. Our firm has seen countless convertible notes issued by OTC Markets companies that probably do not clear the Reves standard of inquiry. First, most of the funds these notes generate are typically used by an OTC Markets issuer to correct cash flow issues – past due rent, pay for regulatory filings, payroll, etc. The funds are not truly being “invested” in the success of the company such as to buy new equipment, make acquisitions, hire key employees or generally further the business. We believe one reason why the court focused on this first issue is that correcting cash flow issues is a short-term fix, not a long-term investment, such as the purchase of equipment. Second, all of the convertible notes we have seen are private transactions between a single lender and the issuer, and not part of a funding transaction, such as a Private Placement Memorandum (“PPM”) where the PPM is marketed to several potential investors and the investors all get convertible notes as part of investing into the company. We don’t believe that several transactions, between a single lender and an issuer rises to the level of the second Reves factor because on the OTC Markets, there is no public market to trade the actual notes. As to the third factor, if the actual convertible note itself cannot be traded, it is highly unlikely that the public would view such an instrument as a security. Convertible notes cannot be publicly traded on the OTCMarkets. Lastly, and according to Reves and other case law, convertible notes rarely reach this factor, but it is important to consider “risk”. Is the convertible note lender actually at “risk” of losing its “investment”? Our answer is a resounding NO. If the note is constructed in a way to always provide positive returns due to the fixed rate discount against market price of an issuers stock, the lender is exposed to very little risk of non-payment. Using the Reves analysis, FINRA concluded that none of the debt obligations held by the prior holders were securities. As a result, “when the prior holders accepted stock in satisfaction of the debt, it was not an exchange of securities that would support tacking.” FINRA Disciplinary Proceeding #2014041724601, Financial Industry Regulatory Authority v. Scottsdale Capital Advisors Corporation et al. (2018). This new level of heightened analysis and information that should be included in 144 opinionletters can also be gleaned from recent SEC enforcement actions against two notable convertible note dilution lenders. In Securities and Exchange Commission v. John D. Fierro and JDF Capital, Inc., No. 3:20-cv-2104 (D.N.J. February 26, 2020) and Securities and Exchange Commission v. Justin W. Keener d/b/a JMJ Financial, No. 20-cv-21254 (S.D. Fla. March 24, 2020), the SEC demonstrates that the SEC is now taking strong action against lenders who buy and sell convertible notes for their own account because they did not register as a “Dealer” under the Securities and Exchange Act of 1934, which was enacted to regulate the OTC and other public markets. According to federal law, any transaction entered into in violation of the registration requirement is void (15 U.S.C. §78cc). It also doesn’t matter if the underlying contract would otherwise be legal. The crux of the both cases is that the defendants in those action bought “securities” (convertible notes), held the notes for six months and then used attorney opinion letters stating that the securities sought to be issued in exchange for the debt satisfy the holding tack-back provisions of Rule144.

The securities of the issuer, issued by the transfer agent, are new shares of stock not already traded in the market. These lenders operate by converting only parts of their notes so as to not exceed 4.99% holdings of all of the issued stock of the company – obviously orchestrated to fly below the SEC’s radar.

Additionally, you do not need to look too far into the past when the old COR CLEARING issued a bulletin (2017) notifying the market that it would no longer clear stock derived from convertible notes unless the opinion letter and other documentary backup demonstrates that the convertible note is in fact a security under the Reves analysis. (

Transfer agents and microcap companies alike need to be on the lookout for thin, insufficient attorney opinion letters and be sure that 144 tacking periods are available only to transactions that in fact involve securities. Transfer Agent compliance and in-house counsel need to confirm that each opinion squares with a Reves analysis.

About the author:

Michelle P. Ferlito, Esq. is a Senior Associate at The Basile Law Firm P.C. handling litigation and General Counsel services to it’s clients.


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