Hill, Thompson, Magid & Co., Inc.
15 Exchange Place, Suite 800
Jersey City, NJ 07302-3912
May 7, 1999
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Mail Stop 6-9
Washington, DC 20549
Re: Release No. 34-41110 (File No. S7-5-99)
Dear Mr. Katz:
Hill Thompson Magid & Co., Inc. ("Hill") was among those who requested an extension of the time to comment on the above Rule re-proposal. We thank the Commission for granting the additional time. It has enabled us to compile statistics that may be informative in the Commissionís deliberations. Further, the analysis has helped Hill to gauge the potential impact of this Rule, if approved, on our business and the market in which we operate.
Hill is a registered broker-dealer, with roots in the OTC markets that date back to the early 1930ís. Today, Hill makes markets in about 7,000 securities, more than 6,000 of which are OTC securities. Most of our OTC coverage relates to OTCBB stocks, but we have been preparing for expanded coverage of Pink Sheet stocks with the imminent availability of real-time priced quotations via NQBís Electronic Pink Sheet system. Hill, as both a small business itself and as an OTC market maker, holds a significant stake in the outcome of the market structure debate that underlies Re-proposed Rule 15c2-11 (the Rule). When the Commission first proposed the changes that it continues to champion in the Re-proposal, Hill submitted its comments. A copy of that letter (dated April 27, 1998, Reference File No. S7-3-98) is enclosed. Its primary point, that other more effective and less intrusive measures exist to fight micro-cap fraud, still pertains.
This comment letter, then, is a supplement to our earlier submission. As such, it focuses upon those areas that are new in the re-proposal. In issuing the re-proposal, the Commission explains that it has made two major changes to its initial proposal that "will significantly change the Ruleís scopeÖ" that is "limiting the scope of the Rule principally to priced quotations and to those securities that the Commission believes are more likely to be the subject of improper activities." We see little practical change in the Ruleís scope, by reason of the new size-price-volume exemptions. Further, we think the emphasis on priced quotations, while consistent with the Commissionís logic (quotations assist manipulators; priced quotations provide focused assistance; therefore, priced quotations are the greater evil), continues to sacrifice progress toward liquidity and transparency in the OTC markets to a retrograde solution.
The Commission estimates that at least 10% of covered OTC securities will be excluded from the Rule under the size-price-volume tests (fn. 25). If accurate, it would appear that approximately 1,000 securities would be relieved of the Ruleís coverage by the new exemptions. Our own analysis of OTCBB reporting securities leads us to believe that the 10% figure is inflated, if not inaccurate. Further, we believe that, even if accurate, the exemptions provide little relief to the securities of U.S-based OTC companies and little relief that would not be provided by other exemptions.
Most of those securities that would be exempted under the tests are removed in any case from the Ruleís coverage. As the Commission itself observes, OTC securities of foreign issuers and, especially, OTC American Depository Receipts (ADRs) comprise the bulk of the 1,000 exempted companies. We find only six ADRs remain on the OTCBB. The others moved to the Pink Sheets when faced with the choice of becoming reporting companies. The Rule will be triggered by priced quotation activity, yet the Commission recognizes that very few Pink Sheet stocks have priced quotes today. ("broker-dealersÖ publish priced quotes for about 10% of Pink Sheet stocks" (p.65)). Thus, very few of these ADR and foreign stocks qualifying for the exemption have the benefit of priced quotes today. Thus, quotations in these securities would not be targeted by the Rule, even in the absence of the size-price-volume exemptions.
Many of those U.S.-based companies that the Commission estimates will qualify for the size-price-volume exemption will not be covered by the Rule in any case in the very near future. They, too, like the ADRs and foreign stocks that moved to the Pink Sheets, will be moving to the Pink Sheets, as NASD transitions the OTCBB to reporting company only stocks. As those stocks move from a climate where today, 90% of the stocks enjoy priced quotations to one where only 10% reflect priced quotations, qualifying for the size-price-volume exemption will matter little. From this perspective alone, the size-price-volume exemption has negligible impact on the Ruleís scope, since most of the stocks that would qualify will be non-reporting Pink Sheet stocks that have historically been quoted without price.
Quantifying Exemption Availability
Approaching the same issue from another perspective, we conducted a survey of the Top 100 list of OTCBB stocks displayed quarterly by NASD on the OTCBB Website. We examined the stocks on this most active list for the quarters ranging from August 1996 through December 1998. 415 different OTCBB stocks appeared on the Top 100 list during this two-year period. Our effort was to determine the approximate number of OTC reporting companies that might qualify for the ADTV exemption. We reasoned that any stock that would qualify for the ADTV exemption would have appeared on the Top 100 list at least once in the last two years.
Two caveats about this approach: First, the ADTV test measures average daily trading volume, as measured in dollars, whereas "activity" for the Top 100 selection is measured in terms of share volume. Thankfully, the OTCBB display includes dollar volume, so we were able to create a database of the 381 candidates and sort by dollar volume. Secondly, the dollar volume exemption requires measurement of ADTV on a monthly basis, whereas OTCBB measures ADTV on a quarterly basis. As an aside, these little differences illustrate some of the difficulties broker-dealers will have under the Rule in determining the availability of the ADTV exemption.
Of the 415 stocks listed among the Top 100 over our survey period, fewer than half, 188 stocks, had even one quarter where their ADTV was $100,000 or more. Of these 188 stocks, 104 were securities of non-reporting companies and will soon be ineligible for continued listing on the OTCBB. Given the historic figures, few will reflect priced quotations once on the Pink Sheets. Moreover, ADTV is far more difficult to monitor for Pink Sheet stocks, given the resources available today. These two factors make it likely that the practicality of pursuing the exemption is questionable for all but the OTCBB reporting companies.
Canvassing those 84 reporting company stocks that might qualify for the ADTV exemption reveals only 33 that appeared on the Top 100 quarterly list in two or more consecutive quarters. The rule would require the ADTV exemption to be established over six consecutive months. Even for these 33 stocks, the availability of the exemption will be a matter of timing. It is important to note, then, that only 5 of the 33 stocks appeared on the Top 100 list in four or more quarters. OTC stocks trade sporadically and, while a small number may be exemption-eligible on occasion, almost none will continuously qualify.
All of these factors, taken together, suggest that exhaustive work would be necessary to claim the ADTV exemption and that work would show little yield in the end. It is almost intuitive that the $50 price exemption and the $10 million-and-over net tangible asset exemption will uncover few stocks that would be removed from the scope of the Ruleís coverage. For instance, a search of equity OTCBB stocks on Bloomberg with shareholder equity of $10 million and more discloses only 245 issuers that qualify. Eliminate intangible assets and the number would certainly be fewer. Further, a search of equity OTC stocks on Bloomberg with two sided quotes disclosed only 99 securities that are trading at prices of $50 and over (and 44 of those 99 are ADRs). Bloomberg is a reliable and comprehensive source. To the extent these figures are understated, it is likely due to a lack of availability of market and financial information.
The Commission makes a backhanded concession in the Re-proposal that "[t]he majority of OTC stocks of U.S. companies Ö will not satisfy for a test based on [the ADTV exemption]." In reality, the ADTV exemption rarely applies, is difficult to determine, and has short-lived application in any case. Taken together, the size-price-volume exemptions will have minimal impact on the Ruleís coverage. The Commissionís estimate that it has excluded 985 stocks (p. 65) that would otherwise have been subject to the Rule is not supportable, based upon the data we have reviewed. Certainly, the size-price-volume exemptions do not, by any measure, represent a "significant change" in the scope of the Rule.
Shift to Priced Quotations
In its 1998 proposal, the Commission imposed, as it does here, the function of gatekeeper on market makers dealing in OTC securities. In the earlier proposal, however, failed reviews or suspicious activity in the markets would precipitate a cessation of quotations, whether priced or unpriced. In the Re-proposal, the Commission changes two things: (1) instead of ceasing to issue quotations, a market makerís remedy for a failed review lies in ceasing priced quotations. Unpriced quotations can continue; importantly, the review itself need not be made (except for the first broker-dealer issuing a quotation in a security), so long as the market maker does not submit priced quotations to an interdealer quotation medium; and (2) subtly, but significantly, the Commission addresses liability concerns of market makers by focusing the review responsibility on the triggering events, emphasizing that the broker-dealerís responsibility to cease priced quotations is restricted to those points in time. The Commission remarks that commenters formed the misimpression that a continuing duty to monitor for suspicious activity was implied in the initial proposal. This is certainly disingenuous, as the 1998 Release, which the Re-proposal supersedes, was peppered with such wide-ranging remarks.
The revised tone of the Re-proposal and the focus shift to priced quotations make less onerous the review and record keeping responsibilities which the Commission proposes to place on market makers. At the same time, limiting potential liabilities and encouraging unpriced markets, as opposed to quote cessation, do not make the Commissionís Re-proposal a better idea. They simply make a bad idea more palatable. While the Re-proposal mitigates the intolerable risks and cost burdens of the initial proposal, they remain unreasonable. Moreover, the consequences for the investor, the issuer and the small business capital formation process have not been ameliorated in any way.
To the contrary, the consequences may arguably be worse under the Re-proposal. The Commission, by distinguishing between priced and unpriced quotations will encourage unpriced markets, where the 1998 proposal established quote cessation as a last resort. Under the Re-proposal the direct cost of undertaking a review of a particular OTC security is tied to priced quotations. That cost includes the overhead of maintaining the necessary resources to conduct a review, the time it takes personnel to conduct that review, the potential civil liability and regulatory costs which making that review implies, and the clerical costs involved in handling and storing data. Surely, with these costs, market makers will be encouraged to select carefully those stocks in which they will maintain pricing and those in which they will go with unpriced quotations.
Those decisions will be made on a cost-benefit analysis that will not necessarily have any relationship to whether a particular security is one that is more susceptible to fraud. The Commission has not accounted for all of these costs in the Re-proposal, but just using the Commissionís figures, Hillís overhead will, within a year of the Ruleís adoption, increase by more than $1,440,000. Without reference to start-up costs and 211 filings, Hill will need to perform an annual review on more than 6,000 stocks. The Commission tells us this will take an average of four hours for reporting companies and eight hours for non-reporting companies. If half of Hillís OTC stocks are non-reporting and half reporting, the average review time will be six hours. At $40 per hour, the review cost per security will be $240 and reviewing 6,000 stocks annually would cost $1,440,000.
Hill could cut that cost by two-thirds by not entering priced quotations in any Pink Sheet security. To do so clearly would not be Hillís preference. The NQB is planning to launch an Electronic Pink Sheet (EPS) market that will offer real-time pricing in stocks. In our view, the transparency and enhanced liquidity that the EPS system will add to the OTC market represents a far superior alternative for all market participants than the barren darkness the SECís Re-proposal will bring to the Pink Sheet market. The Commission will force a return to the OTC market of the past, where investors were deprived of timely market information, because priced quotes were not publicly and easily accessible, and paid more in transaction charges, because wider spreads were necessitated by increased market uncertainties.
To deal with crime, one can close down the streets, deputize vigilantes, and impose martial law. Another treatment might be to put more lights on the street and make the cop on the beat more visible. In part, the choice could hinge on the severity of the problem. While nobody doubts that fraud persists in our markets, conditions have improved, not deteriorated. In June 1994, the SEC and NASD released the 1993 Penny Stock Examination Sweep, which found that penny stock fraud "has been significantly reduced, indicating that regulator efforts to eliminate abusive practices in this segment of the market have been largely successful (NASD Regulatory & Compliance Alert, June 1994). We differ with the Commissionís belief that micro-cap fraud, at least in the OTC markets, has worsened, but it has not, by any stretch, reached the epidemic proportions that would justify stepping backwards in time.
Todayís sophisticated technology makes possible the illumination of price transparency. The enhanced competition and capital commitments that flow from trade facilitating improvements in the marketplace add to liquidity. They also make possible more efficient and effective regulatory efforts. By encouraging unpriced quotations, the Commission not only fosters the wrong environment, it also diminishes the ability of regulators to utilize OATS, compliance "report cards," and other computer-enhanced policing tools.
Establishing a regulatory regime that effectively promotes unpriced quotations through the threat of increased costs, liability, and regulatory responsibility for priced quotations is the wrong approach. This is not to encourage the Commission to return to its 1998 proposal. Again, we disagree with the Commissionís conceptual approach and have sought only to argue here that the "significant changes" the Commission claims to have made in the Re-proposal are either illusory or worsen the situation. As for alternatives, the attached comment letter previously outlined some proposals that we continue to advance and support.
Very truly yours,
Anthony Broy, Jr.