Wednesday, May 8, 2013

Gypsy Swap -- Rule 144 Issue for Pink Sheet Companies


One of the most important issues in a Pink Sheet company is to find paths to raise new money. Naturally, free trading stock has more marketability than restricted stock. A Pink Sheet company cannot file a registration statement with the SEC because they lack the necessary PCAOB audited financials.

In fact, if it was a former shell company, it cannot even sell stock privately to investors and ask them to wait a year to sell under Rule 144 because Rule 144 is not available for a former shell company.

One innovative solution some companies have tried is to do what is called a "Gypsy Swap."

In a Gypsy Swap, the company has a shareholder with free trading stock to sell his stock to a new, cash investor. The money goes to the company and the company issues restricted stock to the shareholder who had the free trading stock originally. The old shareholder keeps his stock position, the new investor gets free trading stock, and the company gets the money.

The SEC does not look kindly on end runs around Section 5 of the Securities Act of 1933. This is the section that requires new sales of stock to be registered with the SEC. Consequently, the SEC has taken the position for a number of years that Gypsy Swaps are violations of Section 5 and the shares received by the new investor are restricted securities under Rule 144(a)(3).

In Zacharais v. SEC, the Circuit Court of D.C. agreed with the SEC, finding that the new investor and the original shareholder were "underwriters," or participants in the distribution.

 A majority of the Court held that the appropriate measure of the disgorgement penalty is 100% of the proceeds of the sales.

The Court found that as the securities in question had appreciated, the company may not have had to disclose the risk that the buyers would rescind the transaction, causing the company material liability. The Court remanded this issue to the SEC.

What is important to you here? Easy, do not do Gypsy Swaps. If you do, you may face rescission if the stock is down, disgorgement penalties and SEC sanctions.

Aged Debt in Pink Sheet and OTCBB Public Shells -- Rule 144 Issues


Aged Debt in Pink Sheet and OTCBB Public Shells -- Rule 144 Issues

In Pink Sheet and OTCBB stocks, there may be convertible debt that is usually called “aged debt.”

This convertible debt can be converted into common stock. For example, it could be a three year note from the company convertible into stock at $0.01 per share.

The conversion price could also be stated in terms of a percentage of market price, for example, the debt could convert at 50% of the market price.

Aged debt means that the debt was issued long enough ago that the holding period requirements of Rule 144 have been satisfied. The holding period, as you may know, for Rule 144 is one year for Pink Sheet companies and six months for OTC BB and other SEC registered companies.

Now we can consider what this means to the company and the holder of the aged debt. Aged debt usually trades at a discount to face value. Suppose you can buy $100,000 of aged debt for $50,000. If it converts into stock at $0.01 and the stock rises in the market to 0.05 per share, you can convert into 10,000,000 shares. At five cents per share, this is worth $500,000 you paid $50,000. Hmmm......

What this means to a shareholder of the company's stock who is hoping for appreciation is that there is going to be a ton of stock on the market keeping the price down. So be sure to look for convertible debt when you do your stock picking. You will find that the existence of this debt is not often featured to stock buyers by stock promoters. They try to hide this. So in addition to all the enormous dangers of speculating in penny stocks, we have this one.

When converting the aged debt, the debt holder is careful to convert only a portion of the debt at any one time so he does not go to 10% of the outstanding and become a control person. However, he can convert and sell and convert and sell and convert and sell and never go over 10% and still dump all the stock he can convert into. If the debt holder goes over 10% of the outstanding, he will be considered to be an insider and subject to limitations on the volume of stock that can be sold, like 1%, and limits on the manner of sale.

You will see OTC shells advertised for reverse mergers that feature aged debt as one of the sales features of that shell.

However, here is where the aged debt players can make a fatal mistake. If one promoter buys control of the reverse merger public shell, and also buys the aged debt at the same time, then he is an insider as he has control. This limits what he can sell under Rule 144. If the promoter uses the aged debt himself, or then gives or sells the aged debt to someone else, the debt is subject to the holding period rules of Rule 144 and the holding period starts to run from the time of the transfer to the associate, not the date of creation of the debt. The promoter may overlook this point either because of ignorance of the law or by deliberately violating the law.

The same problem exists if the debt was in the hands of an insider or affiliate. The holding period for the new buyer starts when the affiliate sells the stock to the new buyer who is not an affiliate.

If another party independent of the promoter bought the debt, and the previous debt holder was not an insider, then the buyer could tack the holding period of the previous holder. Assuming the previous holder had the aged debt for more than a year, the new buyer would have satisfied the holding period rules of Rule 144.

A greedy promoter may give the debt to an associate who will secretly sell the stock and give the proceeds of that sale to the promoter. This is a violation as a false name of the owner was used and because the stock would be attributed to the promoter whose holding period started when he bought the shell and who is subject to the volume and manner of sale restrictions of Rule 144.

Another problem that these promoters run into is that they seem to think that any debt can be converted into stock. Typically an OTC shell company winds up as a shell with some debts. One of these debts is almost always back salary to the company president who was not taking pay because of the bad condition of the company. However, this is a straight debt, not a convertible debt. Thus it cannot be magically transformed into immediate stock. In order to use this, the directors would have to exchange it for a convertible note and the holding period for the note for Rule 144 purposes will start when the conversion feature is created. Straight debt is not a security for these purposes.

Also as all 144 stock has to be paid for in full to start the holding period, debts created for services have to have all of the services fully performed before the stock or securities are fully paid for and the holding period started.

As some unscrupulous characters may attempt to “age” the debt by simply forging and backdating, I recommend that you take your convertible notes to a notary who can certify as to the date it was created and who signed it. Then you will be able to prove your aged debt is legitimate.

One final point, Rule 144 is a tool to allow investors to sell their stock. It is not a rule for financing the company. If you are the company, do not make a deal with a seller of 144 stock to put the proceeds of his sales into the company.