Legal Insights from The Keener Case: Potential Implications for Fund Managers
Introduction
The Keener decision[1] represents a pivotal moment in interpreting and applying securities laws as it pertains to the definition and regulatory treatment of “dealers” within financial markets. This case arose from actions taken by the Securities and Exchange Commission (“SEC”) against Justin W. Keener, who was accused of failing to register as a securities dealer despite allegedly engaging in extensive buying and selling of penny stocks. The decision by the court not only clarifies the regulatory scope of dealer activities but also sets significant precedents that could impact fund managers, individual investors, and the broader landscape of financial regulation. This decision could have crucial implications, not only for those directly trading securities but also for global fund managers who oversee pooled investments and execute frequent trades as part of their management strategy.
Background of the Keener Decision
Justin Keener was a sole proprietor doing business as JMJ Financial, a fictitious name that he registered in Florida in 2008. Keener’s business model involved purchasing convertible notes from microcap issuers, converting those notes into new issues of common stock at a discount of 30 to 40% of the market price, and selling that stock into the public market at a profit. Keener’s lending behavior—converting debt to stock at a significant discount and selling the resultant shares in high volumes— is known as “toxic” or “death spiral” financing. This often caused significant stock price declines, harming existing investors. Keener negotiated these terms directly, rarely allowing prepayment in cash, which would reduce his profits.
From January 2015 to January 2018, Keener's business operations included extensive note purchases from over 100 microcap issuers, resulting in $7.7 million in profits and liquidating billions of shares. He operated from offices in San Diego, Miami, and San Juan, employing up to 25 individuals, including key financial and legal staff. Keener aggressively marketed his “QuickLoan” convertible-note program, claiming to provide up to $500,000 in working capital to microcap companies and advertising his success with over 200 firms. Keener invested over $3 million in proprietary software to identify potential issuers, and his employees contacted hundreds of companies. He also hosted lavish industry conferences to solicit issuers. Despite once being associated with a registered broker-dealer, Keener was barred by the Financial Industry Regulatory Authority (FINRA) in 2012 for non-cooperation in an investigation, preventing future associations with any member.
The SEC filed an enforcement action against Keener for operating as an unregistered dealer, presenting evidence that 93% of issuers borrowing from him experienced stock price declines, primarily harming retail investors. Even while the suit was pending, Keener made materially false statements about his stock holdings. The court granted summary judgment for the SEC, ordering disgorgement of $7.8 million in profits, a civil penalty, and a five-year ban on trading penny stocks, intending to distribute disgorged funds to harmed investors.
Court’s Analysis
In the Keener decision, the central legal issue was the appropriate classification of Justin W. Keener's financial activities—whether he should be regarded as a “dealer” or merely an “investor” within the context of US securities law.
The court’s exploration into the definition of a “dealer” was grounded in the interpretation of Section 15(a)(1) of the Securities Exchange Act of 1934, which stipulates that those buying and selling securities must register as securities dealers if they partake in these activities “as part of a regular business”. The SEC argued that Keener, through his substantial involvement in buying and selling penny stocks, was operating as a dealer and thus fell under this regulatory purview.
Keener's defense hinged on the argument that his trading activities were those of an “investor”, not a dealer, as his transactions were allegedly sporadic and not a part of his regular business operations. He contended that his investment strategy did not provide sufficient systematic engagement with the securities markets so as to necessitate registration as a dealer.
The court, in its deliberation, referred to several precedents but focused substantially on the qualitative and quantitative nature of Keener’s transactions. It considered factors such as the frequency of transactions, the intent behind them, and whether these transactions were conducted in a dealer-like manner, providing liquidity to the markets. A significant point of reference was the “frequency test” that has often been used in similar cases to determine whether someone is engaged “in the business” of dealing securities. This test assesses whether the transactions are performed with regularity and continuity and whether they are central to the business operations of the entity or individual in question.
The court systematically dismantled Keener's defense by highlighting the high volume and regularity of his stock trading activities, which it deemed went beyond mere investment practices. The judgment emphasized that Keener executed transactions on a scale and with a frequency that was inconsistent with typical investment strategies, resembling more closely the operations of a registered dealer. This interpretation was bolstered by citing the intent behind securities regulation—protecting investors and ensuring the integrity of the financial markets.
Another crucial aspect of the court's reasoning was the interpretation of the term “regular business”. The court referenced the historical contexts of the term, indicating that “regular business” implies systematic conduct rather than sporadic or occasional activities. It underscored that the spirit of the law aimed to encompass individuals whose activities could impact market dynamics significantly, justifying the need for regulatory oversight.
The judgment also leaned on the public policy argument, asserting that requiring individuals like Keener to register as dealers serves the broader goal of market transparency and investor protection. By positioning registration as a mechanism for oversight, the court linked regulatory compliance directly to the prevention of abusive practices in the market, thereby affirming the SEC’s stance.
Implications for Fund Managers
The Keener decision marks a significant turning point in the regulatory landscape for fund managers. As the court has elucidated the criteria that define a “dealer” in the context of securities law, fund managers must reassess their activities and operations to ensure compliance with new regulatory expectations.
One of the most immediate implications of the Keener decision for fund managers is the potential reclassification under securities laws. Fund managers who frequently buy and sell securities, akin to Justin W. Keener's activities, may now be considered dealers instead of mere investors. This reclassification carries with it the requirement to register as securities dealers, which entails a rigorous compliance protocol.
Registration as a dealer entitles one to comply with several regulatory requirements, including stricter reporting standards, maintaining a higher level of transparency, and adhering to comprehensive operational and risk management controls. Fund managers, therefore, must evaluate their transaction frequencies and strategies to determine if their activities might now subject them to these dealer-specific regulations.
Keener Decision Under Turkish Law
In Türkiye, the main regulatory body overseeing the securities market is the Capital Markets Board of Turkey (“CMB”), which operates under the framework established by Capital Markets Law No. 6362. In Türkiye, any party that conducts activities classified under the scope of dealing in securities must be registered with CMB. The definition of a dealer in Turkey does not automatically encompass all fund managers as it does potentially under the Keener decision in the U.S., which extends the dealer classification to include private fund managers engaging in frequent trades. Turkish regulations require a specific license for dealing that includes rigorous criteria, not solely based on the frequency of trades but also on the nature and context of transactions. Nevertheless, the core arguments in the Keener decision could provide international guidance for CMB’s approach to the classification of investment services and the scope of dealing in securities.
Conclusion
The Keener decision represents an important case in the area of securities regulation, setting a precedent for the classification of individuals and entities as “dealers” under U.S. securities law. This decision serves as a critical reminder for fund managers and other market participants to reassess their activities to ensure compliance with securities laws, potentially altering the operational landscape for those engaged in frequent securities transactions.
- Securities and Exchange Commission v. Keener, No.22-14237 (US Court of Appeals 11th Circuit) (May 29, 2024) (https://media.ca11.uscourts.gov/opinions/pub/files/202214237.pdf, Accessed on 30.06.2024).
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