Finra May be Getting More Aggressive in Regulation of Microcaps

When Michael Siegel, CEO of EcoloCap Solutions Inc. (ECOS) , signed an agreement last year to sell convertible notes to Asher Enterprises Inc., he knew the money could dilute his shareholders, but he had no idea that months later the agreement would keep his company from completing a 1-for-2,000 reverse share split.

But a Sept. 16 letter from the Financial Industry Regulatory Authority says that the agreement between EcoloCap and microcap financier Asher and a 2013 SEC enforcement action against Asher president Curt Kramer caused Finra to deny the fairly common corporate action.

The denial could be a sign that Finra is now using more discretion and doing more due diligence when considering even the most common corporate actions of microcap companies.

A securities lawyer who has had at least 10 such applications before Finra in the last three months says the securities industry regulator is moving in a more deliberate fashion.

"It doesn't make any difference whether it was a name change, a ticker symbol or reverse or forward splits. Finra is looking at these things more deeply," the attorney said. "They are looking at who the officers are, who the directors are. It doesn't matter what kind of application is being considered. Companies that have solid balance sheets won't have problems, but companies that are shaky are going to be looked at closely."

Finra is responsible for regulating broker-dealers and transfer agents and for tracking trades that take place on domestic securities exchanges and OTC Markets Group Inc.'s (OTCM) platforms, where a substantial number of microcap stocks are listed.

Finra spokeswoman Nancy Condon said the time it takes the regulator to process applications is a reflection of whether the companies provide complete information. She declined to comment on whether Finra was performing more due diligence or whether it had adopted new or different standards for review or enforcement.

EcoloCap, based in Barrington, Ill., describes itself as a network of companies using nanotechnology to develop alternative energy products.

In its second-quarter financial statement, EcoloCap reported no revenue and losses of $622,042 for the first half of the year, and zero cash on hand at the end of the quarter. The company also had $1.88 million in notes outstanding.

Prior to submitting its reverse-split application to Finra, EcoloCap had processed the change with the state of Nevada, where the company is registered, and obtained shareholders' permission to reduce its number of shares.

Finra stated in its letter denying the reverse split that it had "actual knowledge" that the company or people connected to the company or its proposed corporate action "are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations."

The person that Finra was referring to is Kramer, by virtue of the convertible note agreement.

Last November, the SEC announced a settlement with Kramer and his companies Mazuma Holding Corp., Mazuma Funding Corp. and Mazuma Corp. over allegations that they had purchased 2 billion unregistered shares of Laidlaw Energy Group Inc. and more than 1 billion shares of Bederra Corp. Inc. at significant discounts and sold the unregistered shares into the market, making more than $1 million on the transactions.

Without admitting or denying the allegations, Kramer and the Mazuma companies agreed to pay $1.4 million in disgorgement of profits plus interest and penalties.

Finra noted that Asher controls 640.5 million EcoloCap shares and a $32,500 promissory note that will be convertible into stock in January. Converting the note would give Asher about a 10% stake in EcoloCap, Finra said.

An attorney who represents EcoloCap says that the regulator is wrong.

"The magic word is, 'connected,'" said Conrad Lysiak with the Law Office of Conrad C. Lysiak PS in Spokane, Wash. "What does that mean exactly? Kramer is not an officer, a director, a promoter, advisor or transfer agent. Does the company have a debtor-creditor relationship? Sure. But is he connected? Let me ask you this: What if ECOS had filed for a name change? Would Finra be holding that up as well?"

A securities lawyer who is familiar with Finra said the regulator would likely process the name change application because a name change doesn't affect the market, but a change in outstanding shares and share value does.

EcoloCap submitted a notice of appeal of Finra's decision, but failed to pay the $4,000 filing fee, according to a Sept. 30 filing with the SEC.

"I literally had to decide whether to pay my mortgage or pay the $4,000 to Finra," EcoloCap CEO Siegel said.

Lysiak questions why it costs so much to appeal a decision with Finra.

"You can bring an appeal in federal court for no more than $500," he said. "Why is Finra charging so much? It's because they don't want to see any appeals."

Siegel has said in a blog post on EcoloCap's website and in SEC filings that Kramer wasn't connected to the company.

In an interview, Siegel said that the agreement between Asher and EcoloCap is perfectly legal. Siegel said that Kramer paid his fine to the SEC and was not subject to any sort of ban.

"They were looking for any reason to say no to the split," Siegel said. "That's how it feels."

Asher and Kramer, along with related entities like Mazuma, are active providers of convertible debt financing to microcap companies. Kramer, based in Great Neck, N.Y., typically offers high-interest loans that he can convert into stock at deep discounts to market price. Free trading shares can be picked up by Asher at discounts as deep as 70% to the companies' recent trading lows. This structure is often referred to as toxic or death spiral financing.

The companies that avail themselves of this type of finance are aware of how it is viewed by investors. On at least half a dozen occasions in the last year, companies took the unusual step of issuing press releases to let the market know that convertible debt held by Asher had been paid off in full.

Siegel defended his company's use of financing from Asher.

"If it wasn't for guys like Asher, companies like us would be out of business," he said. "They do a service."

Kramer did not respond to a request for a comment.

Laura Anthony, founding partner of law firm Legal & Compliance LLC in West Palm Beach, Fla., said in a recent blog post that Finra's denial of EcoloCap's proposed transaction shows a split between state and federal law.

Before 2010, states had the main authority to approve or disapprove of actions such as reverse splits by companies whose shares were traded over the counter.

But then the SEC approved Finra Rule 6490, which required companies to notify Finra of actions such as reverse splits, dividends or name changes. It also gave Finra power to conduct reviews when such actions were proposed and to refuse to allow the actions when it received incomplete paperwork or when it saw indications of potential fraud.

Finra used its authority under Rule 6490 to deny EcoloCap's reverse split, even though the company had already amended its articles of incorporation on file with the state of Nevada, making the reverse split effective under state law, Anthony wrote.

"Clearly it is problematic when state and federal rules and regulations cause a conflicting result, leaving a board of directors, shareholders and the investing public in a state of flux," she stated. "What is the capitalization of ECOS? In accordance with the state law, the company has approximately 3.4 million shares issued and outstanding; however, according to the over-the-counter marketplace, the company has approximately 6.8 billion shares outstanding. Legally it seems the company has 3.4 million shares of stock outstanding at a trading price of $.0001 and that Finra's refusal to process relates solely to a refusal to re-price the stock as a result of the reverse split and not a broader refusal to recognize the validity of the share reduction itself."

A former Finra enforcement official said that cases like EcoloCap's may become more common.

"They are concerned with the bad actors and they are looking more closely at this niche. I think that is fair to say," the former official said.

OTC Markets CEO Cromwell Coulson said he welcomes Finra looking more closely at companies whose shares trade over the counter.

"Having a more active regulator in this niche will be a good thing for everyone," he said.

More from Mergers and Acquisitions

Could Spotify Be Next on Amazon's Wish List?

Could Spotify Be Next on Amazon's Wish List?

Sprint, T-Mobile Might Have to Do More Than Make Promises to Get Deal Approved

Sprint, T-Mobile Might Have to Do More Than Make Promises to Get Deal Approved

Xerox Received Interest From HPQ Before Fuji Deal: Sources

Xerox Received Interest From HPQ Before Fuji Deal: Sources

Divestitures at Newell Expected in Weeks: Wells Fargo

Divestitures at Newell Expected in Weeks: Wells Fargo

In Biopharma M&A, 'Where There's Real Innovation There's Someone Willing to Pay'

In Biopharma M&A, 'Where There's Real Innovation There's Someone Willing to Pay'