SINGER ZAMANSKY LLP
ATTORNEYS AT LAW
Bill T. Singer
Jacob H. Zamansky1
Franklin I. Ogele2
Aegis J. Frumento
Richard A. Friedman3
40 Exchange Place
New Nork, NY 10005
(212) 344-0394 Facsimile
NEW JERSEY OFFICE
505 Main Street
Hackensack, NJ 07601
Anthony K. Modafferi, III6*
Hugh M. Ross2
1Admitted in District of Columbia and New York
(E-MAIL) INTERNET: INFO@SINGERZAM.COM
October 1, 1997
Jonathan G. Katz,
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
RE: 34-38860/34-38672 : S7-16-97
Dear Mr. Katz:
The following comments are submitted in response to the Commissions concept release 34-38672 (May 23, 1997), 62 FR 30485 (June 4, 1997) ("Concept Release") soliciting comment on its approach to the regulation of exchanges and other markets in light of technological advances and the corresponding growth of alternative trading systems and cross-border trading opportunities. My particular comments are limited to regulatory proposals pertaining to the certification of stock exchanges on the Internet.
Internet Stock Exchanges
I urge the Commission to foster the development and growth of an Internet stock exchange(s). The Commission should permit qualified entities to operate as Internet exchanges pursuant to parameters established during a pilot project. During this pilot period, regulatory and operational issues would be analyzed and effective rules and regulations promulgated in response to ongoing developments. Ultimately, successful candidates should be certified as full-fledged exchanges and self-regulatory organizations, rather than mere variations of broker/dealers or ECNs or ATSs.
A stock exchange should be something more than merely a trading system. Trading systems are not exchanges and it makes little sense to further confuse the public by endowing such electronic facilities with the aura of an exchange. The public perception is that an exchange is a location where proprietary listings are traded, and by proprietary I mean that to the average investor a New York Stock Exchange stock is one which is listed and traded on the NYSE, versus an American Stock Exchange stock, which is listed and traded on the AMEX. The Commission should promulgate rules providing for additional classes of electronic entities, e.g., ECNs or ATSs or electronic trading facilities, rather than to further confuse the public by pretending that what we traditionally describe as an exchange now properly describes these new manifestations.
National Self-Regulatory Organization
In conjunction with properly defining the new electronic entities, the Commission must determine how to best regulate these entities. As the Commission itself has opined in the concept release, requiring that the new electronic facilities be "subject to oversight by self-regulatory organizations ("SROs") that themselves operate exchanges or quotation systems, [which] raise[s] inherent competitive concerns." The most sensible and overdue solution to this problem is for the Commission to either return to a Commission-only ("SECO")form of regulation for these new creatures, or, in the alternative, to promote the development of a unified national self-regulatory organization ("NSRO") which would operate independently of any existing SRO and would provide an independent, unaffiliated forum for adjudication of regulatory matters. As the Commissions historic 21(a) Report of last year all too dramatically disclosed, the NASD engaged in grossly inappropriate abuses of electronic members in a blatant attempt to appease a disgruntled market making constituency. These abuses ran from top to bottom, compromised the integrity of the investigative process, corrupted the adjudicative process, and should serve as a warning against permitting the NASD to engage in the regulation of competitive entities. Further, it raises serious antitrust issues if the operator of the largest over-the-counter facility in the country is permitted unrestricted access to the proprietary secrets and strategic planning of actual competitors. An NSRO would appear to be the only viable alternative to SECO.
The Liquidity Fallacy
The Commission has cited "liquidity" as a factor militating against the certification of Internet exchanges. In essence, the argument is that an exchange must offer more than a mere locale for the display of offers or a facility where orders are executed; in addition, it is argued, an exchange must incorporate market makers or specialists in order to add liquidity to the marketplace. Barring the utilization of such professional traders, it is believed that Internet exchanges are merely electronic bulletin boards. But as many preconceived notions about the contributions of market makers were proven false by the Department of Justices 1996 antitrust settlement with the 24 largest NASDAQ market makers, so should we view with skepticism the application of similar expectations to the emerging electronic marketplace.
As a former regulatory attorney and a member of a securities industry law firm, I firmly believe thatthe majority of todays regulatory problems tend to cluster around the small capitalization securities ("Small Cap"). If the Commission is truly desirous of significantly alleviating much of the present market fraud, then it will favorably entertain the creation of Internet exchanges as both a prophylactic and curative.
The issue of liquidity in Small Caps is a canard. Small Cap market makers do not really provide liquidity, they merely provide the appearance of such, and, I submit, that such appearance has had a terrible cost to the public. Unsophisticated investors, as well as those with investment experience, derive a false sense of security from that fact that a given Small Cap is quoted on NASDAQ or the electronic bulletin board. In reality, the overwhelming economic importance of being quoted on any recognized exchange or association has added pressure to engage in unscrupulous practices at both the issuer and the underwriters level. Quite simply, without the ability to trade on a recognized facility, Small Caps are relegated to a marketplace limbo, only inches removed from Hell.
Why does the inability to get a quality listing cause such havoc? First, issuers seek exposure for their deals in order to ensure the successful placement of their offerings and to provide for the orderly maintenance of their aftermarkets. It is self evident that it is easier to attract investors to an offering whose securities will be readily quotable and easily tradeable. A ready quote must be more than a listing on the pink sheets or a once-a-day closing quote. Similarly, if an underwriters ability to realize profits from Small Caps is significantly tied into a given issues ability to satisfy exchange or NASDAQ listing requirements, then fewer underwriters will be prepared to underwrite non-NASDAQ deals. The result is that legitimate, Small Caps who do not satisfy the NASDAQ thresholds are left to fend for themselves in an often less-than-savory underwriting environment. As has been demonstrated time and time again, the less competition, the more domination. . . the more domination, the more costly capital becomes and the wider the door is opened to organized crime. In essence, our present regulatory structure is driving Small Caps into the arms of criminals because legitimate underwriters are finding it more difficult to bring non-exchange listed securities to market. Furthermore, the massive concentration of non-Exchange listings at NASDAQ has resulted in an inability for smaller, marginal listings to obtain exposure. Not only has NASDAQ become the only game in town for the over-the-counter market, but the inability of smaller, competitive exchanges/associations to develop has produced a veritable monopolization.
What, ultimately, is the Commissions goal? Smaller, regional issuers do not have ready access to Wall Street. Notwithstanding, businesses have a right to compete in the market for investment capital. Why should they be forced to enter by the back door? Why isnt it profitable for smaller investment bankers to undertake calculated risks for non-NASDAQ listings? Why dont reputable market makers regularly service the needs of smaller issuers? The answer is simply that the deck has been stacked through decades of discriminatory regulation in favor of larger broker/dealers and underwriters, to the detriment of smaller and regional industry participants. It has finally gotten to the stage where non-NASDAQ eligible stocks are viewed as a dying breed, intentionally slated for extinction by the Commission.
Market segmentation cannot be prevented, nor is the proper province of government to control such market forces. Long-term, established broker/dealers should attract a different clientele than neweror smaller firms. Similarly, smaller issuers should not expect an entitlement to the investment banking services of a multi-national financial services organization, merely because they need to raise capital. However, the Commission must recognize the needs of reputable, smaller issuers to raise public capital are a vital component of our economy; provided such needs are consonant with the legitimate needs of the investing public not to be defrauded.
This is the essence of the debate and the deliberation. In balancing the competing needs of raising capital and maintaining market integrity, the Commission must be careful not to stifle ingenuity and progress. It is true that in many of the considerations raised in the concept release, technology has outrun the ability of regulators to keep pace. Nonetheless, the Commission must accept the fact that computers have dramatically increased the speed of our times and, as such, we are in an environment which is daily being challenged to adapt to the celerity of technology. A failure by our capital markets to trim the decision-making apparatus at its regulatory level may well doom us to superior competition from foreign markets. If the securities industry in the United States is to thrive into the 21st Century, we must accept the technological challenge and match its pace. It is simply absurd to expect technology to slow down in order to accommodate bureaucracies incapable of making decisions within reasonable periods of time.
The market making myth
If the Commissions concern about the need for liquidity in the Small Cap market is correct, then market makers should be adding some value by participating in the trading of smaller stocks. Recent sordid history has borne out that market making in smaller stocks is often confined to what is known as the Ax in industry parlance: a dominant, call-all-the-shots market maker. Yes, this market maker often attracts a small group of firms to the stock, and, yes, this market maker often is standing behind its bids and offers (for a period of time). But what usually happens is that after a period of time this Ax moves on to another deal and drops its bid to the point where the value of the stock has significantly depreciated and trading results "by appointment" only. As a practical reality at this point, liquidity becomes non-existent.
And why shouldnt the Ax drop its bid to a thirty-second? If the Ax is a legitimate, relatively small firm with a new deal coming to market, why should it continue to allocate significant portions of its limited capital to yesterdays deal? The underwriters function is to bring companies to the market and facilitate the raising of capital. To burden underwriters with the perpetual weight of supporting the same market they created is not promoting liquidity or building a sound economy. The role of raising capital is not innately bound to the role of maintaining an aftermarket. Although sound business practice should dictate that bona fide efforts to raise initial capital ought to be tied to creating and maintaining a sound aftermarket, this is not always practical with Small Caps. Market manipulation and stock speculators have all but ravaged the Small Cap marketplace. But the solution is not the throw out the baby with the bathwater.
Market making and underwriting are not one and the same. Underwriters must raise the risk capital that enables private companies to go public. Underwriters must further ensure that a legitimate aftermarket will exist, such that investors in the IPO will have an orderly market in which to dispose of their holdings. Market makers, in contrast, need not be involved in the underwriting process butearn their profits from the customary spread to which they are entitled for their risk. Nonetheless, market making and underwriting are inextricably bound to the extent that reputable market makers will actively seek to make markets in issues brought public by successful and reputable underwriters. Similarly, successful and reputable underwriters know all to well the value of a stable aftermarket and will seek to attract quality market makers to their deals.
Nonetheless, the public is being done a disservice if it is misled into believing that the mere existence of market makers in a particular stock somehow guarantees liquidity. The public needs to be warned and educated that Small Cap IPOs are risky and unsuited for all but those who can absorb the potential losses. However, the Commission also does a disservice by making access to capital so difficult for Small Cap issuers that they must either abandon resort to public funds or are forced into the waiting arms of the unscrupulous. Properly disclosed risk, calculated risk, is an immutable aspect of capitalism. Once market regulation becomes paternalistic, we lose sight of proper oversight: to ensure an orderly and safe stock market, not to eliminate all risk. The Commission is faced with an historic opportunity to promote an electronic market for the 21st Century and beyond, while at the same time begin a long overdue effective clean-up of the Small Cap market. The key to eliminating small cap abuses is to get at the root of the problem: compensation and commissions.
Small Cap underwriters derive significant compensation from their deals. This is not a unique circumstance, as underwriting at any level is a lucrative enterprise. However, because of the lack of liquidity in the Small Cap arena, the degree of compensation is not often matched by the services rendered. Similarly, whatever benefits are allegedly obtained from forcing smaller issuers to retain the services of an investment banker are frequently outweighed by the likelihood that the only investment banker willing to handle a particular small deal is unscrupulous. Nonetheless, small businesses have a legitimate right to compete in the public market for capital, albeit high-risk capital. The Commissions challenge is to fashion a remedy that provides small companies with a way to raise money that is cost-effective, yet is calculated to reach enough potential investors to provide a reasonable opportunity to actually close a deal.
In recent years several firms have attempted, with mixed success, to raise capital through the Internet. Where the problem often develops in such undertakings is that there is an inability to develop a viable aftermarket. Consequently, even if capital is raised, the issuer is left with a nearly nonexistent aftermarket. Without a listing on NASDAQ, at the least, most Internet issuers trade by appointment only. As a result, if an underwriter is able to deliver any active secondary market, it becomes a significant attraction. However, the quality of these active markets is often debatable, frequently serves little function other than the distribution of insiders stock, and often evaporates within one year of the initial offering.
Providing Investors with Information
Small Cap Internet exchanges could be chartered for the purpose of allowing issuers a unified exchange on which to develop a secondary market. The Internet exchange should not be required to use professional specialists or market makers. Rather, direct linkage to the public should be the preferred mode of trading. Using existing technology and systems already submitted to theCommission for approval, public investors presently have the ability to post bids and asks on bulletin board-type facilities. Similarly, the technology also exists to create a cyber-exchange which can display a full range of offers to buy and sell varying amounts of securities. Further, the same existing technology allows for hyperlinks from a displayed quote to a home page for the issuer, replete with technical and fundamental research.
Warnings about speculative grade investments
I would recommend that the Commission authorize a limited number of pilot projects to permit the creation of several Internet stock exchanges. These exchanges might be limited to initially listing Small Caps. The home page of an exchange would serve as a mandatory gateway and should disclose Commission-mandated warnings. The warnings should note that the Small Cap market is often illiquid and speculative-grade only. The warnings should specify that illiquidity means that there may not be any ready buyers or sellers, and that any offers to buy or sell may be for limited amounts of shares. Similarly, the Commission might consider imposing a mandatory cooling-off period on the purchase of any Internet exchange traded securities, e.g., ten calendar days during which the buyer has the right to cancel the trade. Additionally, to promote liquidity by discouraging excessive trading (in contradistinction to investing), the Commission might impose a minimum holding period on the purchase of any Internet exchange traded security, e.g., sixty days subject to a 10% penalty on any proceeds payable to the issuer or exchange.
Commission regulated trading disclosures
The next link from the exchange home page should be to its quote page. Using existing technology the quote page would display the present value of the exchanges index with historic reference points of daily, weekly, monthly, and annual values, as defined by Commission rules. This display would provide any potential investor with a simple and precise graphical representation of the profit(loss) exposure in the Small Cap market. Following the entry of a requested quote, the investor would receive information presented in Commission approved format. At a minimum, the quote should reflect the best, inside spread and display a range of offers to buy and sell over defined percentage changes in price and volume, e.g., all offers within ten percent of the inside spread, or 50% of all offered volume.
Taking full advantage of current technology, investors should then be able to hyperlink from the quote to a range of information on the issuer. This link might be to an exchange operated page or to a page operated by the issuer. Information available on this page should include any registration or filing materials, and company promotional materials. It would be precisely this additional layer of access to information about an issuer which should be made an integral part of the Internet exchange. Similarly, the Commission should promulgate rules about the types of forecasts, disclosures, etc. that should be available through such exchange-accessed links.
Reducing market fraud and sales practice abuses
Internet exchanges should be viewed as alternatives to the pandemonium in the non-NASDAQ marketplace. Today, a typical Small Cap investor gets a call from a boiler room. The investor never heard of the brokerage firm, never heard of the salesperson, and never heard of the stock. Theresreally no place to get information about the BD, RR, or IPO other than from the brokerage firm. More importantly, theres no readily available index for Small Cap stocks against which to compare. But at an Internet exchange, a potential investor would not necessarily need to deal with a BD, if the offering was in whole or in part conducted over the Internet. Additionally, by giving investors direct computer access to the Internet exchange, the public is not held hostage to the whims of either the BD and RR. This latter opportunity would significantly reduce the ability of firms to enforce a "no sale" or "proceeds only" policy. Further, investors investing through direct linkage could avoid higher commissions or mark ups. Finally, an Internet exchange would be a focused source of comparison shopping. If you are an issuer seeking to compete in the marketplace, you must stand up against the comparison to other similarly situated companies, all of which would be available by a mouse click at the same Internet exchange. By giving the public customer the ability to independently access Small Cap companies, you would effectively eliminate a significant source of fraud, in that a brokers ability to manipulate and control the flow of information to the public will be seriously diminished. As a natural consequence, the public will not be forced to merely rely upon a limited list of so-called "house stocks," being promoted by questionable firms. Ultimately, this expansion of investment information to the public will promote the overall purpose of the federal securities laws by engendering investor confidence in the marketplace.
As to executing orders on a pilot basis, the Commission should require Internet exchanges to utilize the services of approved brokerage firms at which securities and cash would be held. Similarly, as to the clearing of Internet exchange trades, the Commission should require the use of approved clearing firms to handle such transactions in much the same way as traditional market making clearance occurs.
Although professional traders should be encouraged to trade in Internet exchange listed securities, the forum should be created to serve the needs of the public investor and the smaller issuer. Turning the Internet exchange into an off ramp from NASDAQ or a refuge for unscrupulous stock promoters must be avoided at all costs. To this end, the Commission must seek to develop a viable alternative to the penny stock market. By permitting direct public-to-public trading, mark ups/downs would be eliminated. As the Commission has regularly noted, a majority of Small Cap market abuses involve excessive mark ups/downs. Investors would enter their orders electronically at the website, by telephone, or through existing modes by using a broker. If an investor wished to enter an Internet exchange through a traditional broker/dealer, the trade should be on an agency-only basis. Similarly, the Internet exchange should advise investors that trades could be entered on the website without the imposition of any commission. Initially, Internet exchanges might affiliate with specific broker/dealers that would not charge excessive commissions but would limit such transaction charges to X pennies per share or a per transaction fee of $X per trade, providing competitive transaction costs comparable to those offered by leading discount brokerage firms.
One company that is developing an approach in accordance with many of the ideas discussed above is the Internet Stock Exchange, http://internetstockexchange.net. Although not currently operational as an exchange, I believe that this entity has established a sensible means of information presentationand could serve as an excellent candidate for my suggested pilot program. The CEO of the Internet Stock Exchange, Anastasios Kyriakides, is a well-known and successful entrepreneur who has taken his own multi-million dollar companies public and has advised many companies on their investment banking needs. Unlike many developers of Internet securities sites, Mr. Kyriakides approaches the project from the vantage point of the issuer and the investor, not the underwriter or market maker. Further, as a securities industry outsider, he is not favoring any particular approach or solution. However, in my eyes, what may doom Mr. Kyriakides venture is its inability to establish a trading facility on which transactions would be executed. It is precisely the combination of issuer information pages coupled with the ability to offer electronic trading venues that separates the Internet exchange from the typical stock market.
Today I can call a broker and order the purchase of shares in IBM. But I cannot enter my order directly to the Floor of the NYSE, even though I can electronically enter all components of my order at E*TRADE. Similarly, I dont have one-stop shopping where I can visit an Internet NYSE site, download public filings and promotional material on a potential investment, review current trading in that company with full transparency, AND enter an order on a timely basis. Without the coupling of trade execution with information accessibility, the Internet will be doomed to an electronic curio.
Vincent P. Liberti
Singer Zamansky LLP