U.S. SECURITIES AND EXCHANGE COMMISSION
PROPOSED RULE 15c2-11
File No. S7-5-99
The National Quotation Bureau, LLC
May 8, 1999
R. Cromwell Coulson
II. GENERAL DISCUSSION*
B. Theoretical Basis of the Proposed Rule*
C. Loss of Transparency*
D. Civil Liability*
E. Red Flags*
F. Real World Issues with "Red Flags"*
III. SPECIFIC DISCUSSION OF THE RULE*
A. Proposed Rule 15c2-11 - Summary*
1. Basic Operation*
2. When the Review Requirement Applies*
3. Securities Within the Scope of the Rule*
4. Standard of Review*
5. Definition of Red Flags*
6. Effect of Red Flags*
7. Effect of Red Flags on a Reliable Source Determination*
8. Effect of Red Flags on an Accuracy Determination*
9. Effect of Red Flags*
10. Trade Reports*
11. Section 17B*
B. Specific Comments on the Rule and on the Commissionís Questions*
1. Purpose of the Rule*
2. Changes from the Former Proposal*
3. Points At Which Review is Required*
4. Securities Excluded From the Rule*
5. Other Exceptions*
6. Quotations Subject to the Rule*
7. Information Required Under the Rule*
8. Reporting Issuers Delinquent In Their Filings*
9. Issuers In Bankruptcy*
10. Other Non-Reporting Issuers*
11. Information Available Upon Request*
12. Information Repository*
13. Definitions - Quotation Medium*
14. Preservation of Documents And Information*
15. Transition and Exemptive Authority Provisions*
16. Effects On Efficiency, Competition and Capital Formation*
18. Initial Regulatory Flexibility Analysis*
19. Proposed Use of Information*
20. Total Annual Reporting and Recordkeeping Burden*
A. Further Limitation on Insider Trading*
B. Use of Transfer Agents*
C. Primary Market Indicator*
D. Added Authority to Halt Trading*
E. Added SRO Systems Assistance*
F. Task Force*
May 8, 1999
Jonathon G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Mail Stop 6-9
Washington, D.C. 20549
Re: File No. S7-5-99
Dear Mr. Katz,
The National Quotation Bureau, LLC (the "NQB") is pleased to comment on the proposed revisions to Rule 15c2-11 under the Securities Exchange Act of 1934 (the "Act") recently proposed by the Commission.
NQB joins in what it is sure will be a chorus of commentators supporting the efforts of the Securities and Exchange Commission (the "Commission") to address the problem of "fraudulent manipulation of OTC securities." Fraud is a serious concern in all markets, much deserving Commission attention.
The stated purpose of the rule is to "deter broker-dealers from initiating or resuming quotations for covered OTC securities that may facilitate a fraudulent or manipulative scheme." The fact of the matter is that the Proposed Rule will have a very much simpler effect, as represented by the first portion of the quoted phrase. It will all but completely stop "broker-dealers from initiating or resuming [priced] quotations in covered OTC securities."
In short, NQB opposes adoption of the Rule in its current form. The Proposed Rule represents misdirected efforts that in practice will have material effects opposite those intended.
The Proposed Rule Imposes Substantial NEW Burdens. Rule 15c2-11 has long required information collection and review by the first broker-dealer initiating or resuming quotations in a public quotation medium. But the Proposed Rule extends that duty to all broker-dealers when they first enter a quotation medium and when they first enter priced quotations (if later), not just to the broker-dealer bringing the security into the public forum. It converts what has been a balanced effort (1) to assure some public availability of financial and other basic information about an issuer upon admission of its security to trading in a public forum and (2) review of that information as the basis for initial quotations into an overly burdensome, on-going duty to perform fundamental securities analyses and oversee the market. It will not materially increase issuer disclosure or investor access to that information but will create an immense regulatory and operational burden on market makers and the secondary market for legitimate small business issuers.
The Traditional Role of Market Makers Is Seriously and Adversely Altered to One That They are Ill-Equipped to Perform. Market makers smooth discrepancies in supply and demand by risking their own capital. Their pricing methods are complex and probably include some attention to issuer fundamentals from time to time, including historical financial information. But it is clear that once a market has been present for a month or so, the time horizons of market makers are generally forward, not backward, looking and are measured in seconds, minutes, or days, not months and years. The market makerís main concern is future demand and supply, i.e., what the next buyerís or sellerís interest will be.
Historical financial information and much of the other information required by the Proposed Rule loses relevance in that time frame and forward looking perspective. The more so because specific purchase/sale decisions, and attendant revisions in quotes, are typically made in a few seconds when another broker-dealer presents an order in this essentially wholesale market. While the Proposed Rule does not, by its express terms, require review at that time, as later discussed, it has the operative effect of requiring such a review. This, despite the fact that the Release provides no demonstrated connection between such momentary decision-making between professionals and the Proposed Ruleís on-going requirement to review such "ancient history" in an effort to protect investors remote from that transaction. The market maker is insulated from the investor by the broker-dealer presenting the order.
According to the American Institute of Certified Public Accountants, 55% of financial fraud occurred at issuers that had unqualified opinions in the last year of the fraud period. If accountants fail to identify fraud in the majority of situations, why are market makers better situated? The New York Timesí Market Watch Column stated in reference to accounting irregularities at Cendent Corporation: "If Henry Silverman and his team canít spot accounting tricks, even when they are allowed to look at confidential information during the due diligence for a merger, how can the rest of us be confident that we are not being deceived?" Why are market makers any better situated?
In short, market makers are ill equipped to be market overseers. It is simply not consistent with the time-frames, decision-making and fundamental function that they perform. Nor is it clear why they should be singled-out for that role. It is not required of market makers and specialists in other markets. As is the case in those other markets, market makers in covered securities should be market makers not regulators.
The Proposed Rule is Anchored in a Suspect Premise. The Release states that the Proposed Rule is based on the Commissionís perception that:
"The publication of quotation by broker-dealers can facilitate the fraudulent promotion of microcap securities. In our view, the reproposal generally would improve the quality of the markets for securities subject to Rule 15c2-11 and would help protect investors in fraudulent schemes involving these securities . . .. In our view, when broker-dealers must review specified issuer information before publishing priced quotations, they are less likely to become unwitting participants in unlawful schemes of unscrupulous broker-dealers or promoters."
As further discussed below, this passage reveals a critical flaw in the underlying case for the Proposed Rule. The notion that legitimate broker-dealers unwittingly facilitate a fraud by quoting is illogical. To the contrary, their presence is about the only restraining force on the promoters and schemers. That it requires substantial resources and exercise of regulatory authority to distinguish them from the schemers is not a justification for imposing burdens likely to remove their restraining effect, leaving the field to the schemers.
The Release Does Not Present a Compelling Case for Imposing Special Obligations on Microcap Market Makers. It is also not clear what the effect such review of basic information by market makers will have on the quality of the markets that continue to be priced. Frauds arise in all markets and, while this one is a problem, so are the others. Frauds in these markets may be more frustrating because it is harder to justify application of scarce resources to their pursuit and prosecution. But that is not clear. There is a sense from the Release, but there is no demonstration, that the problems are disproportionate in this market. But, the damage to investors and the markets in listed frauds are usually many times larger than in the microcap markets for obvious reasons. It is not even clear that there are fewer frauds in total, although that may be the case. Finally, it is not clear that market makers play any more significant role in such frauds than in other markets and it is clear that the effect of the Proposed Rule may be to facilitate fraud by removing the restraining influence of legitimate market makers. Thus, it is not clear that microcap frauds justify new obligations on market makers that are not applicable to other market makers and specialists. In fact, the burdens on market makers in covered securities are more onerous than if imposed on Nasdaq market makers precisely because these markets involve thinly-capitalized issuers where limited information is available, the lower level of automation present in these markets, the sporadic nature of trading in many issues and other such factors intrinsic to these markets.
The Commissionís Cost Analysis Seriously Underestimates the Burdens. As further discussed below, the cost analysis in the Release seriously understates review costs. NQB estimates costs to market makers, alone, of their attempted good faith compliance with the Proposed Rule at over $100 million per year and more like $300 million per year, not the $5.7 million mentioned in the Release.
This cost explosion over the Commissionís analysis occurs for essentially three reasons. First, it uses a per hour cost appropriate for a clerk but imposes a duty that requires the expertise of a Master of Business Administration or Certified Financial Analyst.
Second, the so-called "piggyback" exemptions have been eliminated. The Proposed Rule now applies to priced quotations of all broker-dealers participating in the market, not just the first to quote a security. That change alone explodes the number of reviews that must be conducted initially and annually. At May 4, 1999, there were 9,980 Pink Sheet and OTCBB issues in which there were dealer quotations. Thus, there was an average of over five market makers issuing priced quotations for microcap securities. Compared to the burden under the current rule, that means an average of at least four more reviews will occur per new security and five more reviews per annually reviewed security. Such growth requires material added staffing throughout the market.
Finally, there is a peak-load aspect to the annual review requirement. The four month period allowed for review of such domestic issuer financial information seems large. But the fact is that most of those months will be consumed by accountants and issuers in preparing the statements themselves. NQB estimates that over 60% of issuers of the 10,000 or so microcap securities report on a calendar year basis. Based on experience with the OTCBB, 96% of quotations are priced. Assuming that quotation levels remain constant, almost 30,000 analyses will need to be performed every year in a window less than a month wide. If those analyses are to be competently performed, it appears to NQB that every year there must be material, added, short term staffing of more than a clerical nature throughout the market.
Red Flags Create a NEW, Almost Continuous Oversight and Review Responsibility that Seriously Increases Liability Concerns. In an effort to respond to comments on the previous rule proposal, the Commission included an Appendix to the Proposed Rule offering Guidance on the Scope of a Broker-Dealerís Review under Current Rule 15c2-11 and the Proposed Rule. The Appendix includes an extended discourse on "red flags", i.e., "information that under the circumstances signals that one or more of the required items of information may be materially inaccurate." Yet, on reflection, the list cites characteristics possessed by legitimate companies in this sector and by many if not most securities in this sector (and many Nasdaq and listed issues as well). In short, the list does not help to distinguish the fraudulent from the legitimate, only to identify a number of commonplace circumstances that might be present in both situations.
Under those circumstances, the search for and resolution of "red flags" is a difficult task at best, and an impossible one for market makers reacting to an in-coming order from a bulge bracket wire-house. Nor is it clear that the Release succeeds in its attempt to confine the hunt to specific points in time triggered by initiating or resuming quotations and Commission issuance of trading suspensions. But, if one accepts the Commissionís goal, that fundamental analysis will limit unwitting participation of market makers in frauds, the real question is what to do on the basis of the information at hand, accurate or not. Is the information of such a nature that trading should stop? Is it only a question of the right price?
On that central conflict, the Release is silent. It leaves only the hanging implication that there are "red flags", which is bad, and that there may be material inaccuracies, which is also, bad. It is one thing to hold accountable the publishers of the misstatements, spinning press releases, erroneous projections and outright mistakes. It is quite another to suggest bases on which to hold accountable third party participants in a market that have, perhaps, read the releases but have little or no capacity to verify or correct them in the relevant time frame.
Thus, the Release provides little guidance respecting the consequences to market makers and investors following from questions such as:
The underlying message of the Release is that responsible market makers should not quote questionable securities. Thus, a security that fits any part of the bad "profile" established in the Release and the accompanying "red flag" discussion is immediately under a market-wide cloud and quotations all but certainly will simply dry up as it appears the Release really expects. That seems extremely unfair to the vast majority of securities singled out by that profile. As any good state trooper or immigration official knows from their use of such profiles in traffic and border patrols, the majority of those profiled are not engaging in any illegal activity. Real effort is required to turn weakly correlated suspicions raised by a profile into real data on which to base effective exercise of the police power. That real work cannot be reasonably expected to occur within the maelstrom of a trading operation and is thus best left to regulators with policing powers.
There will be a Loss of Price Transparency. NQB has been repeatedly assured by responsible market makers that because of the liabilities and costs imposed by the Proposed Rule they will have no alternative but to cease priced quotations in the vast majority of the securities on which they now quote. That result is (1) directly contrary to the Commissionís intentions and the findings of Congress that "the market for penny stocks suffers from a lack of reliable and accurate quotation . . . information available to investors and regulators" and to the resulting Commission mandate to "facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks" under Section 17B of the Act. and (2) inconsistent with the Commission-encouraged requirements of Schedule G of the NASD By-Laws and the last sale reports it has engendered.
That result is also strangely inconsistent with the considerable attention paid by the Commission and Congress to encouraging small businesses and their access to capital. Primary issuance requirements have been eased, yet the impact of the Release appears to all but certainly throttle the secondary market for those issuers. The Commission is only regulating the secondary markets for such securities from an "enforcement perspective." The time has come further to improve these markets for legitimate issuers in furtherance of the Commissionís efforts to improve the markets, primary and secondary. Rethinking of the "enforcement" perspective evidenced by the Release is appropriate.
Retail Operations in These Markets Will Probably Return to the Phone-based Network of Yesteryear. Those assurances of market makers also mean that their customers, the agency brokers, will have to return to the phone-based markets of yesteryear. That will add the costs of executing brokers to the cost analysis mix. Not only does that appear materially inconsistent with 28 years of Commission efforts to "facilitate the establishment of a National Market System," but it is also a material cost not included in the Commissionís analysis in the Release.
Before commenting on specific provisions of the Proposed Rule and addressing the specific questions of the Commission in the Release, there are some high level observations that NQB believes are in order and that, if made once here, in depth, will serve to abbreviate later comments on more specific matters.
Proposed Rule 15c2-11 "is intended to prevent broker-dealers from becoming involved in the fraudulent manipulation of OTC securities." There are two primary routes that shady operators use to prey upon investors: (1) traditional hard-sell boiler rooms, and (2) fraudulent promotion of securities through the Internet and other media. Often, investors will send their orders through legitimate brokers based on an Internet promotion. The globalization of stock markets means that the stock promoted may trade overseas.
But, very substantial numbers of legitimate issuers and others participate in the market segment that contains the targeted abusers. There are issuers who do not meet the standards required for listing on the larger markets and/or do not want to be listed. They are smaller companies with limited operating histories, troubled companies that may or may not dig their way out, and closely held companies with less than 500 shareholders. The issuers may or may not want a public market in their securities. Some of those issuers can, some cannot, and some simply will not provide financial information to minority shareholders or the public. However, all of those issuers have securities outstanding, and as long as the securities exist, minority shareholders and investors will want or need to buy or sell those securities.
There are approximately 10,000 issuers whose equities are quoted on the OTCBB or in the Pink Sheets and an average of over five market makers per security. NQB estimates that the market capitalization of those companies is over $400,000,000,000. The companies employ millions of workers and have millions of public shareholders. In addition to equities, there are over 900 limited partnerships quoted in the Partnership Sheets.
For some time now, Rule 15c2-11 has proceeded from a theoretical base that securities of the issuers in the unlisted market should initially be quoted by broker-dealers on the basis of "fundamentals." NQB concedes the presence of a connection between fundamentals and the price of a security when it first enters (or reenters after more than a temporary halt for news) a public trading forum. However, shortly after that time, there has been a sufficient market so that the time horizons of market makers are materially foreshortened to the next transaction. The market makers are interested in where the price of the security will be tomorrow, the day after, or in the next few minutes, generally not what happened and is recorded as of weeks or months ago in financial and other reports. Heretofore, Rule 15c2-11 has recognized this very basic distinction between the origination of a market and its continuation through what have become known as the "piggyback" provisions.
The Proposed Rule adds annual review requirements and eliminates the "piggyback" exemptions. In so doing, the focus of the Rule shifts from a governor on entry of securities into a public quotation medium based on some minimum attempt at fundamental analysis into a year-by-year reevaluation on the basis of fundamentals with an unspecified duty to take account of "Red Flags" along the way. Those are very significant changes that have serious negative effects on legitimate market makers, legitimate issuers, and investors in the microcap market well beyond those justified by the need to reduce or eliminate microcap fraud.
In so criticizing the theoretical base of the Rule, NQB does not mean to suggest that availability of such fundamental information is not relevant or helpful. It is just that the market should not have to close down if it is not available. The difficulty is with conditioning the ability of independent market makers to enter priced quotes (on the basis of information sufficient to them) that presents the problem, not seeking and encouraging means (such as repositories) by which, if available, such information can be more widely circulated so that all market participants, including investors, are readily able to access and review that information.
In any case, this theoretical underpinning misperceives the operation of these markets and the benefits of permitting responsible market makers to quote notwithstanding a suspicion that information may be unreliable, inaccurate or even fraudulent. Listed markets continue to trade in such circumstances, at least until issuers request or regulators decree that trading should be halted at least temporarily. It is not clear why that should not also be true of the microcap markets. As discussed at greater length below, perhaps another approach to the problem of "penny stock" fraud would be to address that very issue directly with new or amplified rules providing more formalized means for issuers in the unlisted market to seek, and the Commission and the NASD to grant or impose on their own initiative, just such trading halts.
Until so halted that is not how markets operate, generally, and how this market operates, specifically. Supply does not always equal demand in listed or unlisted securities markets. Market makers and dealers, by risking their own capital, tend to level such disparities and provide liquidity for buyers and sellers. Illiquid markets are easier, not harder, to manipulate. By selling, and selling short into rising markets and buying-in during falling markets, independent market makers play a significant, positive role vis-a-vis legitimate issuers and investors. Even when abuse is present, that is positive activity when conducted other than by participants in the abuse. It limits the damage to investors that prove to be victims of the abuse. Investors buying on the way up do so at lower prices than would otherwise prevail, and those selling on the way down do so at higher prices than might otherwise prevail.
Thus, the trick is to separate the scrupulous from the unscrupulous participants in these markets, not to impose across-the-board regulations that, almost by definition, only the scrupulous will observe and that, if observed, will almost certainly result in (a) materially reduced transparency in these markets contrary to the requirement of Section 17B of the Act, (b) materially increased costs to them and their customers, (c) materially increased potential liabilities, and (d) substantially less efficient market operations.
Any one of those effects is a serious concern of market makers, but together these effects are overwhelmingly likely to cause responsible firms to exit the market entirely, leaving it in the hands of less scrupulous firms. NQB is sure that the Commission routinely hears protests, even threats of this nature from opponents to proposed rules. However, even if the Commission substantially discounts them in this instance, these effects of the Proposed Rule will clearly reduce the breadth of the books run by such firms and will undoubtedly cause some to completely exit the market for securities covered by the Proposed Rule. If breadth is reduced and exits occur, there is a serious loss to the markets, the firms and the issuers that is simply not justified even if the Proposed Rule were the only means of addressing the microcap problem.
Section 17B of the Act was added by the Penny Stock Reform Act of 1990. Congress found:
"that (1) the market for penny stocks suffers from a lack of reliable and accurate quotation and last sale information available to investors and regulators; (2) it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to improve significantly the information available to brokers, dealers, investors and regulators with respect to quotations for and transactions in penny stocks; and (3) a fully implemented automated quotation system for penny stocks would meet the information needs of investors and market participants and would add visibility and regulatory and surveillance data to that market."
NQB suspects that few would differ with those conclusions, and NQB is no exception.
As discussed above, it seems clear that the Proposed Rule is very likely to have an effect opposite that desired by Congress and, NQB assumes, the Commission. The Release even recognizes this possibility. It is difficult to imagine how its added requirements would increase, rather than decrease, the origination of quotations in this marketplace. That is so even for the securities exempted from the scope of the Rule in the course of its reproposal. They basically continue as heretofore.
Many More Firms Subject to Duty to Review. Under the Proposed Rule, potential civil liability will be drastically increased for market makers. Under the current Rule, the so-called "piggyback" provisions effectively confine the information collection and review obligations to the broker or dealer first to publish any quotation for a security. By eliminating the "piggyback" provisions, the Proposed Rule requires each subsequent market maker "to review the issuer information . . . and supplemental information described" in the Rule and determine that it has a "reasonable basis under the circumstances for believing that the issuer information . . . when considered in conjunction with the supplemental information . . . is accurate in all material respects and was obtained from reliable sources." Many more firms are subject to these duties.
Many More Reviews for All Firms to Conduct. The Proposed Rule now applies to the first quotation and to the priced quotations of all broker-dealers participating in the market, not just the first to quote a given security. It adds an annual review requirement. Those changes alone explode the number of reviews that must be conducted initially and annually. NQB believes that there is an average of over five market makers issuing priced quotations for microcap securities. That means an average of almost four more reviews will occur per new security and five more per annually reviewed security. This requires material added staffing throughout the market if there is to be anything approaching responsible review performed in each case. The exposure for errors increases commensurately.
Representation to Recipients of the Information. These material and fundamental changes in the current situation lead to materially increased concerns about liability in and of themselves. But things do not stop there. The Release goes on to state that the information about the issuer, the supplemental information, and the information about the broker-dealerís relationship with the issuer must be made "promptly available upon request to any customer, prospective customer, other broker or dealer, or information repository." NQB understands that the inclusion of the term "prospective customer" opens the field of claimants to just about anyone. Moreover, subject to an exception applicable primarily to reporting issuers, in providing the information, the broker-dealer is representing that as of the date of review as recorded in its records, it "had a reasonable basis under the circumstances for believing that the information was accurate and current in all material respects and was obtained from reliable sources."
Liability Conclusions. In short, the Proposed Rule changes the process of review from a obligation for the initial market maker, to an initial and at least annual review process for all market makers. It includes a duty to supply information, and an explicit representation from any supplier of the information to the recipient (which includes competitors of the market maker), concerning the supplierís views at the time of the review. Notwithstanding the Commissionís efforts to define a specific, limited duty to deliver information and an accompanying limited representation about the reliability of its source and accuracy, it strains credulity to suggest that the information can be delivered with impunity in the face of then known (or worse, "should have been known") material inaccuracies present. That basic difficulty is compounded by the long list of "red flags", some of which are present (or worse, arise and become known after the initial review) in the life of many microcap issuers. Thus, that review at the appointed times may have been fully compliant with the Proposed Rule, but requests for information and red flags create material concern about liability exposure from an all but continuous duty to be alert, and exposure for failing to be so.
Thus, the liability environment of market makers is materially altered. It includes not only the sanctions of administrative proceedings but, more significantly, the risk of civil liability under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as the Release acknowledges. While market makers perform primarily a wholesale market function, and thus in that capacity may not be in a direct relationship with some retail customers, many market makers are broker-dealers that also buy from or sell to their retail accounts the stocks in which they make a market. Many courts have held that brokers owe substantial duties of care to their customers, including in some cases fiduciary duties.
If market losses thereafter occurred, individual and class plaintiffs may well institute legal proceedings claiming that these market makers failed to disclose material information (or in fact did disclose materially misleading information) pursuant to their obligations under Rule 15c2-11, and are therefore liable under Section 10(b) and Rule 10b-5. Even if the market maker did not act with actual intent to deceive, recklessness is generally sufficient to constitute scienter in a civil action. In a Commission enforcement action, a mere negligent violation of Commission Rules is sufficient to impose liability for fines and sanctions.
The Proposed Rule thus places a significant additional burden on broker-dealers entering the market in a security after the first to quote, and annually thereafter. By creating an explicit right to information and an accompanying representation, it also increases the obligations of all broker-dealers to their customers and, significantly, to their competitors. In neither case is there an offsetting advantage to the broker-dealers that justifies the assumption of the added risk. If adopted in the present form, the Proposed Rule will certainly drive broker-dealers from making priced markets in a significant number of issuers in which they now enter quotations, thus impairing the liquidity, transparency and competition for microcap securities.
In an effort to respond to comments on the previous rule proposal, the Commission included an Appendix to the Proposed Rule offering Guidance on the Scope of a Broker-Dealerís Review Under Current Rule 15c2-11 and the Amendments. The Appendix includes an extended discourse on "red flags", i.e., "information that under the circumstances signals that one or more of the required items of information may be materially inaccurate."
Even in listed markets, there typically is inaccurate information present in the market, from rumor-mongering short sellers intent on benefiting their short positions, to public relations firms spinning all sorts of news, to missed projections, to just plain mistakes, to scams and fraud. In short, there is lots of information and misinformation in the market. Much of it would come within one or another of the "red flags" identified in the Release.
For example, companies with large assets and minimal revenues is a red flag, but it describes large numbers of startups with real products in development. In this internet age, companies with assets written-up upon getting a patent or trademark (9) will become even more prevalent than they are now. Many of such companies have loans at high rates of interest because the lenders perceive them as involving high risks. Undoubtedly, given the vagaries of the markets, timing of their offerings may not satisfy their current cash flow or "burn rate" needs and necessitate bridge loans from the underwriter or its affiliates (8). Their offerings of securities frequently have use of proceeds sections contemplating reduction or elimination of those expensive loans. None of these things seem particularly unusual or says very much relevant one way or the other to the accuracy or not of that information or other information respecting an issuer. Indeed, they all appear consistent with a real company seeking to get securities to market in a customary manner. In short, these may be aspects of some prior microcap frauds, but they are not distinguishing characteristics of such frauds.
Concentration of ownership of the freely tradable shares (3), reverse stock splits (4), going public through acquisition of a shell company (6), acquisitions of other microcap issuers (10), related party transactions and other footnoted items (14), and large year-to-year gains (17) occur with similar frequency and are not really distinguishing characteristics of microcap fraud. Turning their surface appearances into meaningful information relevant to whether the issuer is real or not involves a substantial inquiry and analysis that is simply not practical for most market makers when there is an existing market of a monthís or more maturity. Thus, NQB suggests that these be dropped from the list unless their meaning and the associated discussion can be refocused upon what aspect of these factors that serves to distinguish frauds from legitimate transactions.
In any case, the search for and resolution of many "red flags" is a difficult task at best. It is an impossible one for market makers reacting to an in-coming order from a bulge-bracket wire-house. The Release attempts to confine the hunt to specific points in time triggered by initiating or resuming quotations in general and after Commission or foreign trading suspensions. It specifically denies that there is a "continuing duty to obtain and review the information." However, while explicit about it in one case, the discussion of "red flags" generally fails to make clear that they are only relevant during a review otherwise required by the provisions of the Rule. Thus, if between first issuing a priced quote and the next annual review, a market maker becomes aware of a red flag or flags of significance, the Proposed Rule appears to contemplate that technically the market maker may continue to place priced quotes. While that is the result that NQB supports and seeks, it is not clearly the result by reason of the tenor of the extended discussion and because of prior remarks of the Commission in the same context. Even the Commission is not clear on the correlation between fundamental analysis of specific current information and day-to-day quoted prices in an established market.
It is also not clear that those well intentioned efforts to define a limited and specific duty are or can ever be successful. First, so limited a duty of review contradicts the basic principle that gave rise to the notion of performing the analysis in the first place. Why is it that "when broker-dealers must review specified issuer information before publishing [their first] priced quotations [and at annual review time], they are less likely to become unwitting participants in unlawful schemes of unscrupulous broker-dealers or promoters" but that is not true more or less continuously when thereafter updating quotes or responding to inquiries?
Second, having learned a great deal about an issuer, including a handful of red flags, the plaintiffís and class action bar will not find it a great challenge to assert that the market maker "knew or should have known" that the information was from unreliable sources or materially inaccurate at the time of a prior review, when the carefully articulated duty to conclude the information was from a reliable source and accurate in all material respects applied.
Third, the Release even creates a duty to continue review. It asserts that a broker-dealer that has filed with NASD whatever was available, and thereafter issues a quote is responsible, after the fact, for reviewing files in the SECís Public Reference Room to determine whether or not information was subsequently submitted or indexed relating back to the period three days before the submission of the quotation. This would suggest that the duty is not confined to collecting and reviewing the requisite information but continuing to monitor file rooms for later filings. It is no longer a momentary duty.
The real question is what the market maker should do at any given time on the basis of the information at hand, accurate or not. Is the information of such a nature that trading should stop, or is it only a question of the right price?
Because of the focus of the discussion on the accuracy of the information, not the issue of concern to the market maker, i.e., the implications for the price of the security in the next few days, the Proposed Rule leaves unresolved and, in fact offers little guidance respecting, the judgment required of the market maker. The entire discussion ends up saying very little about the ultimate question, "Should I stop quoting?" As a result, discussion ends up materially altering the balance between buyers and sellers in transactions where risk taking on the basis of imperfect knowledge is the name of the game for both sides. Legitimate market makers should not be in the position of, in effect, issuing "stop loss" protection to their customers.
As a result, the Release provides little guidance respecting the consequences to market makers and investors following from questions such as those stated above.
In sum, if the Proposed Rule is to afford market makers and others any realistic opportunity to avoid sacrificing themselves before the altar of the plaintiffís bar, the Release will need to be more specific about the times at which there is a duty to seek and review information, the scope of the duty at the identified times and its relationship to red flags, the times at which there is no duty to seek and/or no duty to review information, and the bases for liability or not for breach of any duty or the representation about the accuracy of information furnished. Most importantly, the Release will need to provide hard facts and reasoning explaining the differences in duty and attendant liability. In fact, NQB doubts that these concerns can be satisfactorily addressed and therefore suggests that the Proposed Rule is the wrong approach to the problems of microcap fraud.
The discussion of the "red flag" review process in the release leaves NQB with a belief that no study of the legitimate issues to be covered by the Rule was undertaken. The "red flag" discussion appears to be wholly based on a pathological review of past enforcement actions with little consideration given to the profile of legitimate issuers. As such we would like to point out the ambiguities in applying the search for "red flags" to selected issuers.
Siebert Financial Corp. (SIEB) is a discount brokerage firm. Muriel Siebert was the first female member of the New York Stock Exchange and a New York State Banking Commissioner. When she chose to take her discount brokerage firm public it was through a reverse merger with a shell corporation. SEIB has "red flags" in at least six categories.
Iparty.com (IPTY) is an Internet based retailer of party supplies. It was formed through a reverse merger with a shell company. It is a non-reporting issuer with minimal revenues, no operating history and a market capitalization of over $40,000,000.00. It was founded by Robert H. Lessin, CEO of Wit Capital (and former Vice Chairman of Salomon Smith Barney); Jim McCann, founder and CEO of 1-800-Flowers; and Byron Hero, former CEO of Danskin, Inc. IPTY has "red flags" in the same six categories as SIEB.
United Companies Financial Corporation (UCFNE) is a consumer finance and lending company with approximately 2,000 employees. UCFNE is reorganizing under the protection of the bankruptcy courts due to financial reversals. It is a reporting issuer that is not current in its reporting obligations to the Commission. UCFNE has "red flags" three categories. Market makers would be unable to publish priced quotes in UCFNE under the Proposed Rule because it canít supply the current financial information required by the rule.
While there is no current hint of fraud or manipulation in any of them, all three of the above issuers would be suspiciously profiled under the Commissionís "red flag" review. All three trade with high valuations. Shareholders in all three of the stocks could suffer substantial economic losses on their investments if expectations are not met. SIEB is listed on Nasdaq, so it would not be covered by the rule. IPTY is not so lucky and market makers would be assuming considerable risks in publishing priced quotes. Two legitimate issuers, both with the same profile, but because one is a small business unable to list on Nasdaq, it would have its secondary market throttled.
The Proposed Rule is terribly burdensome to economically distressed issuers such as UCFNE. There are many shareholders that have significant taxable losses on their investment that can only realized as an asset by selling their shares. There are also other investors who may view the shares as an attractive investment and want to average down. Both groups are seriously hurt by the Proposed Rule taking away the benefits of price transparency.
Rule 15c2-11 presently requires the market maker that introduces a security into an inter-dealer quotation medium must obtain, review, and believe certain information for the security. After thirty days, any market maker can quote the security without having to perform the review process. Thus, once a security is in the system, competition and ease of entry are promoted. The new rule proposal will drastically change the market structure.
The rule proposal requires every broker-dealer to collect and review specified information about the issuer of a security (a) when the broker-dealer is the first to quote that security in a public medium, (b) when certain other events occur and (c) on an annual basis if it publishes a price, whether or not another market maker has done so. It also requires that review (1) on entry of its first "priced" quotation, (2) following termination of a Commission suspension of trading, (3) on publishing a priced quotation after 5 days of no or only unpriced quotations, and (4) within four (or in the case of foreign issuers, seven) months after the end of the issuers fiscal year.
The review process applies to the securities of both reporting and non-reporting issuers. Subject to exemptions based on (1) Average Daily Trading Volume, (2) Bid Price, (3) Net Tangible Assets, and (4) certain other exceptions, the Proposed Rule covers "securities quoted on the OTC Bulletin Board . . .; the Pink Sheets . . .; and similar quotation systems."
The Proposed Rule establishes a standard for review requiring market makers to have a "reasonable basis under the circumstances for believing that the issuer information . . . when considered in conjunction with the supplemental information . . . is accurate in all material respects and was obtained from reliable sources." When information is provided to customers, other broker-dealers, and certain others, as it must be on request under the Proposed Rule, the broker-dealer represents that the information met the foregoing test on the date of review by the broker-dealer, not that it meets that test on the date of delivery.
An Appendix to the Rule establishes various so-called "red flags." Red flags include (a) material inconsistencies in the issuer information and between the issuer information and supplemental information, (b) Commission trading suspensions, (c) foreign trading suspensions, (d) concentration of ownership of the "float", (e) large reverse stock splits, (f) unexplained large assets but low revenues, (g) shell corporation acquisition of a private company, (h) Rule 504 offering appearing to get some shareholders freely tradable shares, (i) a registered offering used to repay debt such as a bridge loan, where the underwriters received cheap stock, or where the issuer has no apparent business purpose, (j) a significant write-up of assets on a company obtaining a patent or trademark for a product, (k) a holding company with significant assets in other microcap stocks, (l) substantial assets that were acquired with company stock for which there is questionable value, (m) significant write-up of assets in a business combination among affiliates, (n) unusual auditing issues such as an auditors refusal to certify results, (o) extraordinary items in financial statements, (p) suspicious documents such as inconsistent or altered documents, (q) receipt of substantially similar offering documents from more than one issuer with the same attorney, the same officers and directors or the same shareholders, (r) extraordinary gains in year-to-year operations, (s) missing annual report, (t) disciplinary actions against and issuerís officers, directors, etc., (u) changes of control, name changes, mergers, etc., (v) request to publish a bid and ask quotation for a customer, (w) offer by issuer to pay a "due diligence fee", (x) Regulation S transaction for a domestic issuer, (y) S-8 offering, (z) hot industry stock, (aa) unusual activity in issuer or affiliate brokerage accounts, (bb) frequent name changes, and (cc) frequent changes in line of business. A further red flag arises when another broker-dealer "refuses to substantiate that the information is from the issuer." Suffice it to say that the members of this list are present in a very substantial number of the issuers covered by the Proposed Rule.
The ambiguity and lack of distinguishing character of red flags has already been addressed above in the context of general market conditions and understandings. The discussion here is more specifically focused on the particulars of the Proposed Rule.
Under the Proposed Rule, red flags must be "reasonably addressed" before the broker-dealer may publish a quote. Just what the Release means by "addressed" does not shimmer with clarity. The Appendix states that "When a red flag regarding the sourceís reliability exists, the broker-dealer must inquire further to reasonably determine whether the informationís source is reliable." "When red flags are present, the broker-dealerís efforts to satisfy itself with respect to the accuracy of the information will vary with the circumstances and may require the broker-dealer to obtain additional information or to seek to verify existing information."
Clearly, these statements establish a duty of further inquiry, but say little about the effect of red flags on the ultimate questions of "reliable source", "accurate information", and "do I have to stop quoting?" Nor does further inquiry help very much if the preferred, and sometimes only, source of further information is the issuer of now questionable reliability. Indeed, material inaccuracy in the information would seem a very big red flag all by itself, thereby calling both reliability and accuracy into question.
For example, the Appendix sets out that the "reliable source" requirement, in general, "means that the information was derived from the issuer. If the information is from the issuer or its officers and directors, attorney, or accountant, the broker-dealer generally can assume that the source is reliable, absent red flags to the contrary."
The Appendix goes on to state that reliable sources include EDGAR, another governmental WEB site, an independent retrieval service such as the SECís public reference room, standard research sources such as S&P or Moodyís, or an information repository contemplated under the Proposed Rule. To be a reliable source, the issuerís bank must represent that it has prepared the information or received it directly from the issuer. But these are mostly conduits, not generators of the information.
Frankly, the Commission seems to be struggling to establish in these comments a presumption that the issuer is a reliable source. Such a presumption is very difficult to reconcile with the purpose of the Proposed Rule. It seems to NQB that many of the abuses targeted, and indeed the list of red flags, suggest that issuers are often part of the problem, not the solution. That the data came from this issuer does not seem to NQB to establish much of anything about the reliability of that source. To NQB, this seems more like the Commission seeking to establish an element in the case against the abusers - to trace the information to its source - as opposed to establishing the level of review or reliability appropriate before placing a priced bid or offer in a quotation medium.
The "accuracy as of the date reviewed" requirement has similar flaws. Just because documents are filed with the Commission does not assure that they are accurate. NQB believes that even the Commission would acknowledge that information filed on a form SB-2 is in a different league than information from an S-1 or 10-K. For the reason stated, attachment of liability for filing, it may be more probably accurate than information supplied by non-reporting companies, but again, the Commission seems to trying to establish a presumption of accuracy without saying so.
In short, the discussion of red flags is very confusing. Why is it that a presumptively reliable source (the issuer) should not also be presumed to be supplying presumptively accurate information? Why is it that information many months old should be central, and presumed relevant, to a market makersí determination that a bid or an offer is appropriate?
If a market maker uncovers indications of fraud or manipulation, is the firm supposed to stop trading the security? Why not just change its price to reflect the information? What are a market makerís obligations if third parties are trying to manipulate a security that they trade? Employees of Salomon Brothers were convicted of manipulating the treasury market and employees of Morgan Stanley were fined by NASDR $1,000,000 for manipulating ten securities in the Nasdaq 100 Index. When those manipulations occurred, should all of the legitimate firms have stopped trading those securities?
In its previous proposal, the Commission stated "the broker-dealer would gain a greater understanding of the issuerís business and a better indication of whether potential or actual fraud or manipulation may be present." It went on to state that "After reviewing the information, responsible broker-dealers should refrain from publishing quotations in questionable securities." Not only are these Commission pronouncements a foundation for assertions by injured investors for new duties of market makers to the market in general, they suggest a substantial shift in the perceived roll of market makers. While other markets seek to have bulls, bears, and agnostics interact fully to find a market price, the Commission seems to believe that the market for covered securities should be treated differently and sets a new and incompatible standard for market maker conduct.
The Commissionís viewpoint that responsible firms should refrain from quoting questionable securities will create a law of negative selection that falls right into the hands of manipulators of covered securities. When red flags appear, responsible firms will quickly cease quoting. That will make it easier for promoters to complete their "pump and dump" schemes and will open the door for manipulative short sellers to conduct bear raids on legitimate growth companies. Why? Because any responsible market maker will have ceased quotations that currently are the only available "real-time" indications that there may be fraud or manipulation afoot. Manipulators can easily conduct a "cyber-smear" of a company by posting accusations of fraud or wrongdoing on the WEB and make a legitimate issuerís secondary market disappear.
With the number of quotations after adoption of the Rule in its present form likely to be substantially lower in covered securities, the Commission should consider the effects of last sale reporting under Section 15(g) and Schedule H to the NASD By-Laws. In the absence of real-time quotations, there may be serious risks present.
Trade reports are much easier to manipulate than firm quotations. Last sale information is history. Somebody had to do a trade. But the parties to the trade could be related and the price fictitious. Quotations, on the other hand, are a prediction of things that may come to pass. They generally have more than passing validity (perhaps not as much as historical reports) because other market participants easily (1) quote their own, more reasonable prices, (2) attempt to hit quotes that are out of line, (3) police firms not honoring their quoted markets and (4) place "backing away charges" with NASDR.
Thus, abusers can much more easily "paint" a last sale tape by transactions among the abusers than they can "paint" a quotation feed, at least if responsible market makers are entering priced quotes. In the absence of real-time quotations, other market participants cannot effectively police or display their better prices when they see trades through their markets.
If the rule proposal does substantially reduce the amount of available quotation information, that result conflicts with the Commissionís duties under Section 17B of the Act. That section states that "The Congress finds that; 1) the market for penny stocks suffers from a lack of reliable and accurate quotation and last sale information available to investors and regulators; 2) it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to improve significantly the information available to brokers, dealers, investors, and regulators with respect to quotations for and transactions in penny stocks"
The stated purpose of the rule is to "deter broker-dealers from initiating or resuming quotations for covered OTC securities that may facilitate a fraudulent or manipulative scheme." The fact of the matter is that the rule as currently presented will have a very much simpler effect represented by the first portion of the quoted phrase. It will stop "broker-dealers from initiating or resuming quotations in covered OTC securities."
Whether or not the quotes of legitimate market makers "facilitate a fraudulent or manipulative scheme" is the very point at issue. A number of commentators on the previous proposal and undoubtedly a large number of the commentators on this proposal will question the basis on which that latter phrase is included.
Market makersí level supply and demand by providing risk capital, buying when others wish to sell and selling when others wish to buy. The information they require in order to assess relative supply and demand is a very much more real-time function related to industry developments, company press releases, internet chat rooms and other indications of supply and demand, and, when available, may involve reference to financial or other information that is likely to be much less current. In the last analysis, however, the market makersí decisions involve momentary decisions that in fact restrain the activities of less scrupulous firms because selling into a rising market acts as a brake on price increases just as buying in a falling market acts as a brake on price declines.
Whether or not the market maker is the opportunist that he was supposed to be in the performance of his market making function or a participant in a fraudulent or manipulative scheme involves other facts not likely to be included in issuer financial information.
The Commission believes that the modifications to the rule from the former proposal address commentators concerns because the scope of the rule has been largely limited to an impact on priced quotations and to those securities that the Commission believes are more likely to be subject to improper activities. The release contains no substantive discussion, much less empirical evidence, to support those views.
For the reasons just stated, priced quotations of legitimate market makers may serve to deter improper activities and to provide investors with some indication of the value of the securities they hold or wish to acquire, based on current supply and demand rather than hyped information. Although suspicions may exist, there is no empirical evidence to support the notion that any given segment of the securities markets contributes more to the injury of investors than any other segment. Fraud is a problem in listed as well as unlisted markets and while the nature of the fraud may vary, the very fact that listed markets have larger capital bases, higher valuations and more shareholders, may lead to much larger injuries than in the smaller markets addressed by the Release. It is just not clear why the Commission believes that securities of larger issuers or securities that have a substantial trading price or that meet minimum dollar value of average daily trading volume, are less likely to be involved in frauds than those of smaller issuers that have lower trading prices and lower daily average volumes.
NQB does not quibble with some of the Commissionís edits to the prior rule proposal such as the involvement of a rating agencyís or on the exemption of asset-backed securities. NQB does, however, quarrel with the notion that securities not meeting such tests are more likely to be the subject of improper activities than others.
Initial Quote. NQB supports so much of the Proposed Rule as requires the broker-dealer that issues the first quotation for a security (priced or unpriced) to obtain and review certain material. That broker-dealer may well be related in some fashion to the issuer, and in NQBís view, a non-arms length relationship to the issuer is all but a sine qua non of microcap fraud. Whether that relationship is positive or negative so far as improper activities are concerned, it is consistent with long-standing practice of the Commission to require disclosures at the points and time in the life of an issuer when such market making activity might first arise. Precisely because there may be a relationship between the market maker and the issuer at that point in time, it does not seem unreasonable to impose on the market maker the added burden of obtaining and reviewing the necessary information at that moment and time.
There is a legitimate question about a market maker who has no such relationship ("an independent market maker") that in good faith seeks the information and, as is sometimes the case, fails to obtain it because insiders or others are not disposed to make it available. Perhaps an exception could be created revolving around public disclosure by the broker-dealer of the relationship information in the rule demonstrating the broker-dealer's relationship and permitting the firm to provide price liquidity to the presumably minority shareholders trapped by such a position by the issuer.
Trading Suspension. The first quotation following a Commission trading suspension is another such point in time where disclosure is appropriate generally, but there are exceptional circumstances where leeway may be required. The sort of exceptions NQB has in mind are where the issuer is a troubled company, perhaps in reorganization, or the interests of creditors and the bankruptcy trustee may not align with investors. In such instances, the market makerís obligations probably should be satisfied if it obtains and reviews whatever information is available in the court records respecting the bankrupt.
Four/Seven Months after Year-End. The last three points in time are interesting for what is not said about them. From the discussion in the Release, it is not clear what empirical or other basis there is for concluding that, once there has been quoting in the security, any of these three points in time are all that much more material than any other point in time from the point of view of the validity of the then existing market. Thus, if there has been a reasonable trading market driven by supply and demand factors as would be expected, the presence or not of more current financial information four months after the end of the fiscal year, while it might at first blush appear relevant, is not really the basis on which the market is being made or sustained. Nor is it clear why the quotations of legitimate market makers would be any more susceptible to manipulation or fraud before or after the release of such figures. The same thing applies to the foreign issuer case where the only difference is that there is a seven-month window after the release of the figures.
Five Days Without a Quote. From the discussion in the Release, it is not clear why a broker-dealer that has not entered priced quotations for five business days should be required to conduct a fresh collection and review if there has been a continuous market from other market makers during that period. This may be just another way of objecting to the withdrawal of the "piggyback" exemption, but it seems to NQB that, at a minimum, a much longer period should be provided. What empirical or other basis did the Commission employ to determine the five day period?
It is simply a fact of life in the microcap market that an active security one day is tomorrowís inactive one, and vice-versa. Withdrawal by a market maker for some considerable time may indicate no more than the market makerís reallocation of scarce trader resources to more active issues. Moreover, a news release could mention possible fraud in the market for a particular issuer of, say, a gold mining stock. That might well lead to a level of uncertainty in the marketplace where some market makers would be unwilling to participate until the situation clarified. Even if supplied by the issuer on request, financial information at that point in time would likely be stale and provide little or no assistance in evaluating the current circumstances. News reports, whether from press releases of the issuer or independent investigative reporters, are much more likely to be relevant and informative but not necessarily determinative.
However, it is not clear why on the sixth day an independent market maker must conduct the collection and review contemplated by the Proposed Rule in order to resume quotations on the basis of whatever information is satisfactory to that market maker, assuming, of course, that no trading suspension has arisen in the interim. That there might be a fraud going on and the market maker may lose his shirt is no reason to trap existing stockholders in their positions or to prevent speculators from establishing positions, so long as there is a flashing, buyer beware, sign which the news report should surely have established.
Where the market maker is not independent because, say, it has accumulated ten percent or more of the outstanding securities of the issuer (whether or not in its inventory account), or has previously been an investment banker or underwriter for the issuer, is of course relevant information that should be disclosed and available. This is primarily a wholesale market where that relationship will become quickly known to the retail brokers likely to be inquiring for that market. Even so, it may be appropriate in such as case to impose the added collection and review requirement on such a non-independent broker-dealer.
Generally, NQB supports exemption from the Proposed Rule (and the existing rule) of (1) listed companies (whether domestic exchange, Nasdaq or foreign market), (2) issuers reporting to other official recorders such as banking and insurance regulators, and (3) all debt instruments (including those convertible into listed securities). The markets themselves should be responsible for trading abuses in the first case and the other issuers and securities do not seem to be where microcap fraud is prevalent.
The average daily trading volume test proposed in the Release does not really address the targeted portion of the microcap market - abusers. As noted earlier, securities fraud is committed in listed as well as unlisted markets, by reporting as well as non-reporting companies and in foreign as well as domestic securities.
Q1. Should the dollar value of ADTV for this exclusion be higher than $100,000, e.g., $500,000 or $1 million, or should it be a lower amount, e.g., $50,000? Commenters should provide data and analysis to support suggested revisions to this proposed threshold.
Q2. Should the dollar value of ADTV measuring period be longer than six months, e.g., twelve months, or be shorter, e.g., three months? Should the length of the measuring period depend on the amount of the value of ADTV threshold, i.e., should a lower value of ADTV threshold be allowed but require a longer measuring period?
Q3. Should the exclusion based on ADTV value also incorporate a value of public float test, like Regulation M does? If so, should the public float value be $25 million or some higher or lower amount? Would public float information be easy or difficult to obtain for non-reporting issuers?
Q4. Rule 101 under the Commissionís Regulation M excludes from that ruleís trading prohibitions securities with a value of ADTV or $1 million or more, using a two month measuring period, if the issuer has a public float value of at least $150 million. Should Rule 15c2-11ís exclusion parallel the terms of this exclusion?
Questions 1 - 4: NQB has difficulty seeing any solid connection between almost any dollar or share volume, or public float, threshold that might be set and the potential for abuse. It is rapid change in those volumes and the ratio of float to issued shares that are of more concern. In short, NQB would be surprised if there is any reasonable, statistical or other basis for connecting average daily trading volume, the period over which it is measured or the public float with the likelihood of microcap fraud by a specific issuer. The problem with suggesting a move to using rate of change and float to issued ratios as a basis for exclusion is that there are too many legitimate reasons for change to make the test useful. When all is said and done, however, NQB favors this exemption on the basis that it limits the effect of the new burdens imposed by the Proposed Rule.
NQB does make one suggestion in this regard - that the Commission seek information from the NASD about the distribution and trading in its OTC bulletin board stocks to see whether there are any useful quantitative tests such as those suggested by the Commission which could be applied to this segment of the market.
However, NQB shares a vague feeling that the abuses of concern tend to be in lower priced securities with high trading volumes, at least for a time. For that reason, it suggests that there should be a low volume exemption. Uncharacteristically high volume seems to be a sine qua non for abuse. There should also be a substantial share price test if there has been a market with some daily volume for some time, but it should be two separate thresholds, not a product of share volume and price.
Q5. Should this exclusion be based on a bid price higher than $50 per share, e.g., $100 per share or lower, e.g., $20 per share? Commenters should provide data and analysis to support suggested alternatives to the proposed threshold.
Q6. Should this exclusion be available only if the security has a bid price of $50 over a specified period of time?
Q7. Should this test be based instead on the securityís last sale price? If so, should there be a time limit added to such a test so that a stale last sale price cannot be used?
Questions 5-7: For the reasons just discussed, NQB has its doubts about the bases for this exemption. NQB thinks the statistical analysis just suggested might assist the Commission in answering its Questions 5 and 6 respecting the bid price test.
As to Question 7, as previously noted, it is much easier to "paint" a last sale tape than a quote tape where multiple market makers are present. Last sales can be arranged between co-conspirators. It is also the case that sporadic last sales may not be indicative of the value of many securities in the microcap market. However, where the last sale is materially different from the quote, that might provide an indication triggering the responsibility of dealers placing priced quotations actively to disclose the details of their relationship to the issuer, if any.
First, NQB notes that the size of a companyís assets is not really relevant to its potential for abuse. A $3 million company can still be real and a $1 billion one a fraud. Indeed, what at first appears to be fraud may be something less, merely a mistake.
Second, NQB notes that the focus of an exemption dealing with tangible net assets may be misplaced in an increasingly information-based economy. Intellectual property of all types is an increasingly important asset of material value to many issuers, many of them currently residents of the microcap market. The fact that intellectual property is intangible and less susceptible to reliable valuation than other asset classes, at least in the absence of revenue streams or other indirect indications of its value, in no way diminishes the importance of those assets in the emerging economy and the related markets for shares of companies owning them. NQB recognizes that there may be a need to exclude certain perennially abused intangible assets such as goodwill, and perhaps even intellectual property, but NQB thinks that the issue is more one of disclosure than of exclusion. Thus, if there is an appraisal by an accounting firm or other independent reference, perhaps certain classes of intangible assets should be allowed (perhaps after a "haircut" for uncertainty in valuation) in reaching this threshold.
It is NQBís impression that the financial statements likely to be supplied have been prepared by the company itself or by accounting firms not much better known than the issuer. In that context, it is very difficult to establish thresholds such as those set forth by the Commission.
Q8. Should the threshold amount for this net tangible assets test be higher than $10 million, e.g., $20 million? Under what circumstances would it be appropriate to permit a lower threshold amount? Commenters should provide data and analysis to support their views on whether the threshold amount should be raised or lowered.
Question 8: Because it is in some sense a defining characteristic of the very market in question by reason of section 12g of the Act, NQB believes $10 million is as relevant and useful as any other number.
Q9. For ease of compliance with both Commission and NASD rules, should this exclusion parallel the exclusion contained in the NASDís proposed rule that would require broker-dealers to review current information about the issuer of an OTC security before recommending a transaction in the security? The NASD proposal would exclude the securities of issuers having total assets of at least $100 million and shareholdersí equity of at least $10 million, based on audited financial statements.
Question 9: No. NQB supports the NASD approach but not the thresholds specified which are much too high. Raising the threshold would have the effect of denying the exclusion to the bulk of the microcap market. NQB however supports what it considers to be the more constructively focused approach taken by NASD, but again the thresholds are much too high. The referenced NASD Rules are directed to conduct of the retail broker-dealer not so much the market maker. It is hard to imagine the pump and dump scheme where recommendations were not used. And, the retail broker-dealer and market makers making recommendations to their own retail customers should be responsible for the recommendations made. Almost by definition, a market maker does not make recommendations but simply provides a market when requested by other broker-dealers or its customers.
Q10. Will there be sufficient information in financial statements, particularly those of non-reporting issuers, to permit broker-dealers to make the net tangible assets calculation?
Question 10: NQB is skeptical that there will be enough information to support a test of this nature, but open minded. Financial information on non-reporting issuers is very spotty. Typical Dun & Bradstreet reports have payables data, but not much more. But there is no harm in providing the exemption. If the calculation cannot be made, NQB understands that there is no exemption.
Q11. Should the use of financial statements of a foreign private issuer be limited to financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP)?
Question 11: NQB thinks the answer is "No." As previously indicated, the markets of concern here are generally driven by information factors less related to the financial statements than to supply and demand. Indeed, as the average daily trading volume test recognizes, the vast majority of the trading in the securities concerned may be abroad. Thus, the relevance of the financial statements and whether or not they are prepared according to generally accepted accounting principles diminishes substantially. In short, financials prepared on any recognized basis consistently applied should suffice to permit an objective evaluation of the underlying securities against a market that has traded them for a reasonable period of time.
Q12. Should the use of financial statements of a foreign private that are not prepared in accordance with U.S. GAAP be limited to financial statements prepared in accordance with the accounting standards promulgated by the International Accounting Standards Committee (IASC)?
Question 12: For the same reasons NQB is not clear that using International Accounting Standards Committee regulations is any more relevant. The question is the consistency of the rules applied and the sufficiency of the information contained to permit correlation with the market. Certainly, IASC standards meet the foregoing test and should be allowed, but it is not clear that IASC should be the only acceptable standard.
Q13. Should all three of the tests based on value of ADTV, bid price, and net tangible assets be incorporated into Rule 15c2-11?
Question 13: If the Proposed Rule remains substantially in its present form in other respects, then NQB believes that all three of the tests based on the value of average daily trading volume, bid price and tangible assets should be incorporated in the rule to limit its burdensome application to the smallest number of covered securities. However, they seem unnecessary if as suggested above, the Commission reverts to the current Rule, perhaps shifting emphasis from disclosure of information about the issuer to disclosure of information about the broker-dealer.
Q14. Should the proposed exclusions from the Rule be limited to those securities that satisfy at least two of the three tests?
Question 14: NQB sees no reason that the proposed exclusions should be combined in any fashion before securities are excluded from the scope of the rule. If anything, NQBís problem with the Rule is that the thresholds and exclusions are set sufficiently high so that they do not adequately address the concerns of many small issuers in the microcap market, that the markets for their securities will effectively disappear. The effect of requiring a combination of those exemptions would simply be to raise the bar further.
Q15. Are there other tests that are more appropriate to exclude the securities of larger, more seasoned issuers from Rule 15c2-11? For example, should a security that has no or very minimal trading volume be excluded from the Ruleís requirements? What would be an appropriate low volume threshold? If trading volume suddenly exceeded the low volume threshold, would broker-dealers publishing quotes find it easy or difficult to have to obtain and review information before continuing to publish priced quotations?
Question 15: As just mentioned, "Yes", there should be an exemption for securities with low or no trading volume. Almost by definition these are not susceptible to microcap fraud. The essence of the abuses that have garnered the Commissionís attention are schemes that require a volatile and active trading market to arise, at least for a brief period of time. It is also the impact of the Proposed Rule on these issuers and any broker-dealers interested in making markets in their securities that the requirements of the Proposed Rule fall most heavily.
Q16. Should this exclusion apply to all asset-backed securities or should the exclusion apply only to asset-backed securities that are rated investment grade on the basis that those securities are even less likely to be subject to fraudulent activities?
Question 16: The exclusion should apply to all asset-backed securities. This is not so much a question of microcap fraud as it is the fact that asset-backed securities are traded by large and sophisticated investors rather than the less sophisticated retail investors that are typically the victims of microcap fraud.
Q17. Should the Rule exclude all non-convertible debt and non-participatory preferred stock or should the exclusion apply only to non-convertible debt and non-participatory preferred stock that are rated investment grade?
Question 17: All non-convertible debt and non-convertible preferred stock should be excluded. Except in the case of convertible debt securities (which should be generally exempt along with other debt issues) where the frequency of fraud seems not to be an issue, NQB believes that the question of exempting convertible securities should be by reference to the underlying security into which conversion occurs. Thus, preferred stock convertible into an exempt listed issue should itself be exempt.
Q18. Should unsolicited customer orders be required to be identified as such in the quotation medium? Is it feasible for quotation mediums to show that the quote represents an unsolicited customer order?
Question 18: NQB supports and will include a flag in the Pink Sheets indicating whether or not the quotation is an unsolicited customer order as opposed to a quotation from the broker-dealer. Inclusion of other such helpful flags is also feasible for NQB, e.g., identifying reporting issuers, non-reporting issuers with information available in a repository, and non-reporting issuers for which no information is available.
There is one added provision that should be considered respecting issuers that have fallen on hard times. There might be an exclusion during their court or trustee supervised reorganization. It seems to NQB highly unlikely that securities actively under the supervision of a court or a trustee would be the subject of microcap fraud or other abuses.
NQB supports the operation of the current Rule which, as the Commission states, is substantially what the Proposed Rule would require. NQB suggests one alteration in the interest of facilitating the operation of the repositories later contemplated by the Proposed Rule. There should be a provision allowing an issuer to submit the information to a repository so long as there is agreement between the repository and the NASD that information so submitted will be promptly forwarded to NASD.
As the Commission accurately observes, the use of unpriced quotations is not a feature of microcap abuses. On the other hand, the loss of priced quotations, indeed, the loss of multiple priced quotations, is a serious impediment to the operation of these markets because a quotation medium can no longer be used to satisfy requirements such as the three quote rule. The very presence of numerous quotes in a reasonably related range of prices provides some modest assurance that the prices are reasonable.
Transparency, especially in this emerging age of on-line trading, is an essential characteristic of an operative marketplace, the importance of which cannot be understated. Indeed, the existence of quotations from independent market makers that do not line up with the rising quotations of abusers, may be one of the only effective means of preventing microcap abuses as opposed to later, less satisfactory exercise of the police power.
It is in this Section, and in the related regulatory flexibility analysis later in the Release, that the Commission evidences a serious misunderstanding of the burden imposed on broker-dealers by the Proposed Rule. The legitimate microcap market is largely a wholesale market. Prices are established by market makers who, precisely because of the low value of the securities involved, the intermittent trading in many of the issues, and long periods between trades in many of the issues, must cover many more securities than might otherwise be true of market makers in other markets. They also must be free to move between the issues that have lost their support at a particular point in time to more active issues that have suddenly become hot.
Peak-load. The loss of the "piggyback" exemption and the annual review requirement are very serious burdens on their resources that cannot be understated. The first place where there is a substantial difference between the Commissionís analysis and reality is in the peak load nature of the problem that the rule creates with the annual review requirement. The vast majority of the issuers of microcap securities will be completing their fiscal years on December 31. Thus, a large number of securities must be reviewed in a very short period of time and the fact that there is a four-month window is not really helpful because a material part of that window will be consumed by the issuers themselves in arranging for the financial information to be available. In fact, many of them will not even have the information on or about April 15 when related tax and other returns will probably need to be filed for the shareholders and principals in those issuers. Major players such as Knight Securities will find themselves reviewing thousands of securities in a few weeks. That cannot be accomplished with current staff levels.
Cost of Analytical Staff Understated. Moreover, contrary to the indications of the regulatory flexibility analysis, the review required by the Release is by staff that are very much more senior than the $40 per hour rate used in the Release.
Elimination of Piggyback Exemptions. The so-called "piggyback" exemptions have been eliminated. The Proposed Rule now applies to priced quotations of all broker-dealers participating in the market, not just the first to quote a security. As previously discussed, that change alone explodes the number of reviews that must be conducted initially and annually and creates a significant new personnel requirement.
Added Five Days Without a Quote. The Proposed Rule adds a requirement that collection and analysis be performed by a broker-dealer that has not entered priced quotations for five business days. NQB has no idea how often this happens, but suspects that once again, an inquiry to NASD might surface relevant information based on the OTCBB experience. However, it seems clear that collections and analyses not now required will be needed by reason of this requirement. That further escalates the costs that should be considered in the Commissions analysis.
Added Visits to SEC Reference Room. As mentioned below, the Proposed Rule requires a broker-dealer that has filed with NASD whatever was available and initiated or resumed quoting, after the fact, to review files in the SECís Public Reference Room to determine whether or not information was subsequently submitted or belatedly indexed relating back to the period three days before the submission of the quotation. This adds yet more cost and burden not accounted for in the Release, and, for reasons discussed below, is an unreasonable requirement in any event.
Thus, NQB believes that the Release has seriously underestimated how the Proposed Rule will encumber the broker-dealer community and asks that the Commission reconsider this analysis.
It is also the case that an annual review, if there has been any kind of a market during the year, is much less relevant than the supply/demand and the other information factors mentioned earlier. Like the company that has fallen on hard times, the fact that something could be discovered from such information that might serve to correct the market and bring it to a more rationale relationship to the fundamental value of the issuer is not the concern of the market maker. It is the concern of the securities analyst.
Q19. Should the Rule cover all broker-dealersí initial quotations, whether priced or unpriced, as the earlier proposal would have? Will the reproposal cause broker-dealers to publish unpriced quotes to avoid complying with the Rule?
Question 19: The Rule should not cover the initial quotations of broker-dealers if there is already a priced or unpriced quotation in the quotation medium. NQB supports application of the Rule to all broker-dealers making the initial quotation whether priced or unpriced.
However, we support there being no annual review requirement for unpriced quotes. Otherwise, the Commission would be creating a black market or offshore market for the many covered securities for which current information is not available or trading volume, etc. does not justify the market makerís effort in complying with the Proposed Ruleís collection and review requirements. The securities exist and their holders will continue to need to buy and sell them.
Q20. Should the rule apply exclusively to priced quotes, i.e., the Rule would not cover any unpriced quotes?
Question 20: As just mentioned, NQB supports application of the Rule to all broker-dealers making the initial priced or unpriced quotation in the medium.
Q21. Are there other approaches that would be more appropriate, e.g., to cover any initial quote for a covered OTC security by a broker-dealer, whether priced or unpriced, but not to apply the Rule or at least the annual review requirement to reporting issuersí securities? How would such a proposal help reduce instances of microcap fraud?
Question 21: NQB has reviewed the Commissionís trading suspensions for the past five years. The ratio of reporting to non-reporting issuers that have been suspended is comparable to the general population of stocks in the OTC universe. As a consequence, NQB does not see any statistical basis for limiting the annual review to non-reporting issuers. In fact, many of the non-reporting issuers have current information available in third party securities manuals and have issued press releases for significant events.
The annual review requirement is excessively burdensome in all cases so NQB favors any exemption from it. However, exempting only reporting issuers seems to harm non-reporting issuers and their market makers for no cause shown. Moreover, it seems especially to burden the smaller portion of the small business community.
NQB identifies below in Section IV other approaches to the limitation of microcap abuses. They do not involve changing the scope of the rule insofar as it applies to priced or unpriced quotations.
Q22. Is the Rule text sufficiently clear in identifying he quotation events that are subject to the Ruleís provisions? Are there other quotation events that should be covered by the Rule?
Question 22: The Proposed Rule is not clear on whether there is still a piggyback exemption for unpriced quotations and whether there can be unpriced quotations without collection and review if a security that has been quoted at any time in the past. It is sufficiently clear insofar as the quotation events that should be covered by the Rule and NQB has already commented on those events. NQB has mentioned an added event - breaking of a low trading volume threshold.
Q23. Should the provision pertaining to a lapse in quotations of five consecutive business days or more provide for a longer time period, e.g., ten consecutive business days without a priced quotation, or a shorter time period, e.g., three consecutive business days without a priced quotation?
Question 23: As already noted, the absence of a given market makerís priced quotations for a period of time is not necessarily correlated with microcap abuses. This triggering event for review seems to assume that after five days without priced quotations the situation is the same as when a security first enters the public markets. In NQBís view, five days is indicative of nothing having to do with fundamental shift in focus and the need for a review requirement. As already noted, the ebbs and flows in this marketplace could easily lead to hiatuses in trading of much longer duration having little or nothing to do with the presence or not of microcap abuses.
NQB notes in passing that the phrasing of this question could be read to contemplate a lapse of priced quotations from all market makers for five trading days. As NQB understands the relevant provision of the Proposed Rule, it is a market maker-specific requirement that would apply whether or not a priced market remained for the securities of that issuer during those five days.
In either case, rather than a few days, it is appropriate to permit a longer lapse in trading, say, six months. Even then, the fact that the issuer was at one time established as a legitimate entity, but there has now been a substantial hiatus, may be more indicative of the fact that the company is not the subject of microcap abuses, than the fact that it is or may be. Recurring interest in trading may be brought about by a death in the family of a closely-held company, renewed interest in the marketplace and in the market sector addressed by the company and its technology, and any number of other factors that are essentially neutral on the presence or not of microcap abuses.
Q24. Should the Rule give broker-dealers the option to conduct the annual review as of the anniversary date of the initial quotation by the broker-dealer?
Question 24: Unless the anniversary date of the initial quotation by the broker-dealer has some significance in the life of the issuer, such as a private placement or small offering, under one of the Commissionís small business rules, it is not clear what relationship that anniversary has to the fundamental issues addressed by the financial information of the issuer. Indeed, the information could be quite stale on that anniversary. However, since the Commissionís suggestion is stated as an option, NQB, on balance, thinks it might be a worthwhile alternative to include.
NQB generally supports the notion that information such as that required by the Proposed Rule be available. It notes, however, that provisions permitting quotations after a failed, good faith effort to obtain the information are only appended to certain portions of the information requirement for non-reporting issuers. Thus, a private company that refuses to provide financial statement information can effectively preclude priced quotations for its securities notwithstanding that it may have substantial minority shareholders seeking to exit from any relationship to the company for their own reasons.
If there is a broker-dealer willing to quote a price on whatever information is available, even if that price is in some more informed world, too low, NQB has a hard time understanding why it should not be permissible for those minority shareholders to sell their holdings based on a quotation in a public medium. There is no indication that these circumstances are likely to involve microcap fraud. In fact, if NQB understands the usual scenario, the required information is freely available in most abuse situations. A lack of information may indicate other abuses not commonly thought of as part of microcap fraud. Information requirements of an SEC Rule are not likely to deter the perpetrators of a fraud.
In allowing the publication of unpriced quotations, the Commission has helped with this aspect of the Rule but it has seriously impaired the transparency and fairness of the market respecting legitimate issuers and market makers. As just noted, issuers are not always cooperative precisely because they donít want minority shareholders to be able to exit from a company or for other reasons.
Again, NQB is perplexed, because the microcap abuses to which the Proposed Rule is really directed generally do not suffer from the absence of information but rather too much information of the wrong kind. Thus, NQB is not clear on why this requirement of the Proposed Rule is present. It seems to follow from an effort to mitigate the effects of eliminating the "piggyback" provision, but it is not clear that it addresses microcap fraud.
Problems with delinquent reporting do not seem to NQB to a proper subject in which to enlist the assistance of market makers. It does not seem appropriate to penalize minority stockholders and market makers when it is issuers and perhaps insiders that are causing the delinquency.
As already noted, lack of availability of detailed financial information during the course of a bankruptcy proceeding is unlikely to be the location of microcap abuses. Insofar as NQB is aware, the same is true of companies recently exited from a bankruptcy as the Commission has recognized in proposing to accept reorganization plan documents as adequate disclosure. NQB would be interested in whether or not any of the Commissionís files reflect significant abuses in either circumstance.
Q25. Are there circumstances in which a broker-dealer should be permitted to publish priced quotations for the securities of delinquent reporting issuers in bankruptcy? Please describe these circumstances. Should the Rule prohibit broker-dealers from publishing unpriced quotes for the securities of these issuers?
Question 25: NQB reiterates, for the reasons just stated and for the reasons previously discussed, priced and unpriced quotations should be permitted for independent broker-dealers and for non-independent broker-dealers that actively disclose their relationships at the time of any inquiry respecting their market. NQB really sees no difference between that situation and the one permitted by the Proposed Rule relating to confirmed reorganization plans.
Q28. Should the Rule require the disciplinary history information for the insiders of all issuers of covered OTC securities, and not just insiders of non-reporting issuers, on the basis that microcap fraud can involve issuers whose insiders have histories of prior misconduct?
Question 28: Where it is available, it is appropriate for the Proposed Rule to require examination of the disciplinary history relevant to the issuer and others irrespective of whether the issuers are reporting companies. The problem is availability of the information. But if the broker-dealer is unaffiliated with the issuer, NQB sees no reason why is should not be able to publish a quotation in the absence of the information.
Q29. Are the financial statement requirements, including the presumption regarding when the information is considered current, clear and capable of being complied with by broker-dealers publishing quotations? Should there be longer time periods for the presumption regarding when the financial statements for a non-reporting foreign private issuer are considered current? If so, what time periods would be appropriate?
Question 29: Financial statement requirements including the presumption regarding when the information is considered current are reasonably clear, but they are not capable of being complied with by broker-dealers publishing quotations in many cases. NQB sees no correlation between the fact that information is current and the likelihood that the company is engaged in, or a victim of, microcap abuses. Indeed, the relationship may be inverse. In most cases, NQB suspects that current information is available for abuses precisely because it is necessary to execution of the fraud.
NQB concurs with the Commissionís belief that greater availability of the information to investors is desirable. NQB therefore supports the requirement that the information be made available, although, because of the repository suggestion made slightly later in the release by the Commission, NQB believes that the broker-dealer should be able to comply with that requirement through use of materials in the repository rather than having to have the materials on hand and be provided directly by the broker-dealer. NQB does not mean to suggest that the broker-dealer shouldnít be able to provide this material if it chooses to do so, only to provide a mechanism whereby the operational burdens on and the liability concerns of the broker-dealer could be reduced by relying on the repository.
Thus, in the case of NQB and the repository that it proposes to establish, assuming that it can meet the Commissionís requirements in that respect, NQB would be prepared to deliver information on the instruction of its customers to electronic or postal addresses and would hope that the Commission would see its way free to permit broker-dealers to satisfy their obligations in that fashion. As already mentioned, as a conduit, NQB requests that the Commission provide a safe harbor excluding liability on the part of NQB for acting in that capacity.
Q31. Should we require broker-dealers to make the information available to anyone who requests it, particularly if broker-dealers are permitted to charge reasonable fees? Should broker-dealers be required to provide information to fewer classes of persons?
Question 31: NQB believes that it is not reasonable for broker-dealers to be required to provide the information to anyone that requests it, if there is any liability of the broker-dealer for acting as a mere conduit. Any other outcome presents a "stealth" collection and review requirement further aggravating the burdens already at intolerable levels.
If a broader safe harbor cannot be provided, NQB also agrees that the Commission should continue to include the portion of the Proposed Rule that says that the provision of the information by the broker-dealer is not a representation that the information is accurate. However, the nuance in this section between accurate at the time it was reviewed and accurate at the time it was provided will be lost on the outside world and is meaningless in terms of the liability exposure that this section of the Proposed Rule will generate for quoting broker-dealers. Claimants against the broker-dealer that provides inaccurate data will quickly assert that the broker-dealer knew or should have known at the time of the review that the information was inaccurate. Whatever may be the outcome of that debate, NQB suggests that it is appropriate that any repository, as a mere conduit, be accorded even greater leeway.
Finally, NQB notes that this is a wholesale market and there is a discrepancy between the customer to which NQB believes this requirement is addressed and the person that actually makes the inquiry of the market maker. Thus, NQB understands that the information that would be provided by this requirement would be provided to another broker-dealer that received an unsolicited inquiry from its customer. If NQB understands the Commissionís intent in this respect, a market maker providing information to another broker acting for its customer is not what is contemplated by this section of the Rule.
NQB agrees that a repository is an interesting notion of a positive nature that should be pursued by the Commission and interested private parties. NQB plans to make application to the Commission to become such a repository.
NQB notes, however, that the liability discussion earlier in this comment addresses issues of great concern to the repository as well as to quoting broker-dealers. In NQBís view, it is unlikely that either constituency will be willing to continue if the exposure remains as it currently is under the Proposed Rule.
The current definition of Quotation Medium is too broad by quite a bit. It includes traditional paper-based "publications", chat rooms and e-mail, as well as devices such as squawk boxes. It would even appear to include under the "device" subprovision the turrets and telephones used in a traditional fashion to speak to other broker-dealers.
The existing ruleís piggyback exemptions and separate definitions of quotation medium and inter-dealer quotation system serve to prevent fragmentation of the marketplace. If piggybacking is restored to the Proposed Rule, care should be taken to assure the same result under it.
The clarifications by the Commission respecting the use of ATSs are helpful, but do not complete the necessary interpretations for a broker-dealer using an ATS to enter an agency order for a customer. The discussion seems to contemplate that submission of a quotation by a broker-dealer means an order as principal, not agent, but it does not make that distinction shimmer with clarity. It would be useful for the Commission to clarify whether an agency order submitted by a broker-dealer through an ATS constitutes a bid or offer from the broker-dealer submitting it to a quotation medium that triggers the requirement to comply with the Proposed Rule and whether the solicited or unsolicited nature of that order has any effect on the requirement.
Although the recordkeeping requirements of the Proposed Rule are burdensome in some respects, generally, NQB does not believe there is any difficulty with requiring that whatever records are to be kept must be kept for the time period required under Rule 17a-4. NQB also supports the provision under which broker-dealers need not keep information available separately as long as they document and review information accessible via EDGAR or a repository. NQB would support a requirement that to qualify as a repository, it must retain the information for the same length of time.
As previously mentioned, so long as a repository has agreements in place to supply the information to NASD, NQB sees no reason why the submission should not be permissible directly to the repository, leaving to the repository the retransmission of the information to NASD, and the SEC where appropriate.
NQB is horrified, however, by the notion that a person that has filed with NASD whatever was available and issued a quote is thereafter responsible, after the fact, for reviewing files in the SECís Public Reference Room to determine whether or not information was subsequently submitted or indexed relating back to the period three days before the submission of the quotation. If a reasonable effort was made at the time three days before the submission of the quotation, NQB can see no reason for requiring an ongoing surveillance of information filings by broker-dealers directed to determining what information might have been on file at that time but was missed because of delays in filing or indexing by the Commissionís file room.
NQB does not believe that the Proposed Rule will have positive effects on efficiency and capital formation not already substantially realized under the current Rule. A significant factor in any secondary market is the availability of multiple quotations in a given security. Their presence, rapidity of their change, spreads, increments in which they change, and any other factors, are heavily in the chemistry and intuition that market makers use in evaluating whatever information is available. To be sure, sometimes that information is highly misleading and part of microcap abuses. However, because of the liability concerns addressed herein and the statements of market makers to NQB, NQB is clear that the effects of this rule will be to reduce the number of priced quotations in any given security. In effect, the operation of the Proposed Rule in its current form, and especially the combination of eliminating the "piggybackí provisions combined with the portions of the Proposed Rule that require a reasonable basis to believe that the information is accurate and obtained from a reliable source, will clear the field of independent market makers that contribute to that intuitive and external information flow. The Proposed Rule will leave behind priced quotations only of those that are intent on committing abuses. For that reason, NQB believes that the Proposed Rule will have detrimental effects on efficiency and capital formation along the lines discussed by the Commission itself in the proposing release without any offsetting benefits.
The secondary markets for securities covered by the Proposed Rule are substantially wholesale in nature. The NQB estimates that approximately 80% of quotations are submitted by the twenty most active market makers. These firms are either wholesale market makers that offer execution solutions in all OTC securities (Nasdaq, OTCBB and Pink Sheets) or specialist boutiques offering wholesale markets in industries or sectors (banks, insurance, distressed, inactive securities, etc.). Small businesses are able to gain substantial efficiencies in the secondary trading of their securities by having these firms provide a liquid and competitive secondary market. The vast majority of these firms have no relationship with issuers and do not recommend transactions in the securities in which they provide a secondary market.
Market making firms invest substantial amounts in information technology, automation and straight through processing to create a highly efficient, secondary marketplace. The firms use economies of scale to offer execution solutions in OTC equity securities. As such, small businesses greatly benefit from the low marginal cost of providing market making in additional securities. Their efforts are extremely cost sensitive.
The goal of the wholesale market making firms is to offer a "supermarket" approach. They identify a portfolio of securities where they can compete effectively against others to provide liquidity for buyers and sellers and earn a profitable spread with acceptable risks. As part of the portfolio approach, firms attempt to offer execution solutions in all securities in which their customers have a buying or selling interest. The firms do not create demand, instead they react to demand. In whole, these firms competing in an efficient and transparent medium are good for investors and the capital formation process.
The largest firms have informed NQB that the majority of them will cease to quote securities covered by the Proposed Rule, and virtually all will cease to publish priced quotes in any securities covered by the Rule. That will significantly increase the costs of trading for investors and stifle the secondary market for small business securities. The increased costs will be detrimental to the cost of capital specifically and the capital formation processes in general for small businesses, as all investors need an exit strategy.
The Proposed Rule will have an overwhelmingly negative effect on covered securities. The reputable, well-capitalized and highly efficient market makers will cease to quote covered securities. Efficiency will decrease, competition will diminish and the capital formation process will suffer.
As already indicated, the costs to the broker-dealer community are badly underestimated by the Commission. NQB has been advised by any number of its subscribers that the four-hour and eight-hour estimates of the Commission in this section are simply unrealistically low. It is also the case that the average of $40 an hour assumes the use of largely clerical staff which, especially if the liability provisions of the rule remain as they are, simply will not be the quality of staff used. In short, NQB has been reliably advised that the cost to the broker-dealer community will be vastly greater than as stated in the Release.
NQB also challenges the Commissionís assumption that non-reporting issuers maintain their financial information in compliance with prevailing accounting standards, and in most instances, would have available updated financial information prepared in accordance with generally accepted accounting principles. This sentence assumes a willingness and capacity to provide the information that is simply not present in many cases. In practice, and by operation of law under Section 12 of the Act, this segment of the market is not required to have such information available other than for whatever reasons management may wish to have it. It does not mean that they have not raised significant amounts of money from family, friends and others, in perfectly legitimate offerings and private placements authorized by other rules of the Commission. In many instances, the companies have grown materially over time and have very valuable securities in the hands of people that inherited them or otherwise came into possession of them by legitimate transactions not involving the market making community.
It also appears that the Release does not exhibit adequate concern for the sensitivity of this marketplace to costs in general. As just noted, on a gross basis, it is a low margin business where small changes in costs can have significant impacts.
NQB sympathizes with the Commission's inability to get the information about the number of issuers of OTC securities. Unfortunately, NQB is not in a position to help much. NQB believes that there are over 9,000 companies, but has no basis for that estimate other than its extended experience with listings of securities in the Pink Sheets and the ebbs and flows of the listings therein. As the Commission has no doubt detected, however, NQB feels that the effect of the Proposed Rule will be devastating to thousands of issuers, effectively extinguishing any market that ever existed for their securities. NQB further believes that that effect will have a significant negative impact on investment and innovation in precisely the segment of the markets which has been the engine of the economy's recent growth.
As a service provider to this sector of the marketplace, NQB has its views on the dangers of the Proposed Rule and believes that they represent the views of that marketplace to a considerable degree. However, the under-represented participants in that market, particularly the issuers, should have an opportunity to speak for themselves. As entities directly affected by the Proposed Rule but not directly regulated by it, and as entities many of which are exempt from regular reporting requirements, their normal monitoring arrangements, if any, would not likely discover the Commissionís proposals. NQB asks that the Commission make some effort better to include these affected and interested parties. That might be accomplished in part by posting the Release on the Commissionís WEB site in the section of Pending Initiatives of Interest to Small Businesses. It would also seem appropriate to consult with the Office of Advocacy of the Small Business Administration.
NQB questions the assertion that "because information about these issuers is not widely disseminated and often is not current, fraudulent and manipulative schemes are easier to perpetrate." NQB believes that frauds may in fact be harder to perpetrate precisely because of those factors. The hallmark of microcap abuse is wide dissemination (for that market) to gullible audiences of fictitious quotations and activities, not to a small or inactive group.
For the reasons already stated, NQB believes that the Commission's use of the four and eight-hour figures as the estimated requirement will be unrealistically low. The percentage of priced quotations in the Pink Sheets is also seriously low. NQB believes that its introduction of electronic Pink Sheets will bring the percentage of priced quotations to a level comparable to the OTCBB.
Having identified a fundamental respect in which the Proposed Rule is misdirected, NQB presumes to suggest some alternative approaches to the problems of "penny stock" fraud in an effort to make its comments more constructive. The focus of these suggestions is on identifying the participants that cause the abuse, and limiting their profits and access to the victims of their abuse, not so much identifying and performing analysis on the securities through which the abuse arises. As noted above, that is really the issue - separating the scrupulous from the unscrupulous participants in these markets.
Given the potential for abuse perceived by the Commission, perhaps the principles already in place for other secondary markets could be refined and applied to this one, especially as to non-reporting issuers. Insiders (traditionally defined) in non-reporting companies should not be freely trading their stock against public quotations if there is no information in the marketplace. Nor should the non-reporting issuers be able to purchase shares through published markets. Insiders, and issuers, should not be able to trade, while limiting the minority shareholdersí liquidity options by refusing to provide the required information.
Such refinements of existing regulations would have at least four salutary effects. First, the Commissionís response to the perceived problems is focused on the entities where the likelihood of abuse is the highest, not independent broker-dealers with serious secondary-effects for investors. Second, the burden of compliance is placed at the doorstep of the chief beneficiaries of the public market - potential abusers, not independent market makers or the Commission. Third, disclosure might, in fact, occur more often than it does now or would under the Proposed Rule. Such insiders are more likely to be in a position to provide the requisite information without great burden than are unaffiliated broker-dealers. Fourth, the ability of such insiders and the issuer to transact (for at least some period following publication of the required information) against published quotations would serve to increase the leverage of independent broker-dealers to seek and receive the desired information under existing Rule 15c2-11.
Of course, minority shareholders and the public should be entitled to buy and sell interests in such issuers against public quotations in as transparent and competitive a medium as reasonably possible. They should be exempt from, or provided a "safe harbor" respecting, the limitations suggested above. Their ability to abuse the markets is lower. They are not in nearly the position that insiders occupy when it comes to manipulating prices.
Registered transfer agents could furnish a significant portion of the required information in reliable form. Their obligations under Section 17A of the Act would need to be expanded, but not greatly so. Transfer agents could be required to report to any exchange, NASD, state securities administrator, repository or inter-dealer quotation system or quotation medium that asks (a) on first becoming the transfer agent for microcap securities and (b) thereafter, say, annually. Such a report should be required to at least one such entity and could contain without great burden to the transfer agent much of the information contemplated by the Rule regarding the issuers and securities listed or quoted, e.g., issuer name and address, officers, state of incorporation and shares of the security authorized, issued and outstanding. Transfer agents could also be required to report names of more than 10% holders and significant intervening events such as securities offerings, stock splits, issuer name changes, moves and other events that the Commission deems important.
While the Commission only has power over transfer agents registered under Section 17A of the Act, NQB believes that the majority of non-reporting issuers use such agents. This approach will not reach all issuers in the problem market, but it will reach a significant number of them. Transfer agents have contractual relationships with issuers that puts, or could be amended to put, them in a position to collect factual information. The exchanges, NASD, inter-dealer quotation system, quotation media and repositories can then distribute the information to other market participants.
For the same reasons that liability is such a concern for market makers, transfer agents will probably not accept a role expanded as above discussed unless there is exculpatory relief from all liability other than to the issuer and regulators. Of course, gross negligence, willful misconduct and fraud should not be excused.
NASDR might consider sales practice rules that identify the primary market for a security. That would help separate foreign from domestic issues, differentiate domestic securities by market, provide a firm basis for requiring marketplace risk disclosures and reinforce the prestige of more senior markets such as Nasdaq and the exchanges. As a result of such steps, the public would no longer view all securities with assigned ticker symbols as having the same risk characteristics.
NASDR and other SROís regulatory divisions could be granted added authority to stop member firms and associated persons from transacting any non-reporting security for, say, ten or twenty trading days. Such a rule would allow market surveillance forces instantly to stop trading in a security simply as a precaution on suspicion of manipulation or questionable information in the marketplace.
Such a rule would have many benefits. Abusers would be instantly stopped from gaining further from their abuse and from injuring new investors. That comes at the cost of stopping buying or selling by current investors (whether or not victims), but the halt is only temporary unless investigation reveals abuse. Moreover, investors and market makers might prove more wary of owning speculative issues if their trading could be halted with no warning (unlike a Section 12(k) suspension where the market is invariable alerted by the Commissionís subpoena of documents). The best way to limit fraud is to cut down on the potential for fraudulent profit.
The NASD is presently developing the Order Audit Trail System (the "OATS"), to track customer orders in NASDAQ equities. OATS might be expanded to include all non-NASDAQ OTC equities, be they OTCBB, Pink Sheets, unlisted or foreign. OATS could include whether the order was solicited or unsolicited, the registered representativeís CRD number and the branch office. That would give NASDR a valuable tool in tracking where orders are coming from in times of unusual volume or price change. NASDR would also be able to discipline firms for not using the "solicited" flag and, if it was used, recognize and examine firms with excessive solicitation practices.
These are not all new ideas. NQB is sure that if the considerable resources of the Commission, SROs, and the microcap market are brought to bear, other, possibly better and less disruptive ideas may emerge. To that end, NQB asks that the Commission, state securities regulators and the NASD form a permanent joint task force on fraud to consider and recommend further action.
For example, it seems clear that the secondary markets need more policemen on the beat. NQB offers its support for added funding of regulatory efforts directed to this need. Rather than impose gigantic costs on participants in these markets, and burden them with substantial intangible costs and effort, it may be better to devote added resources to such patrols.
Insofar as solutions to the fraud problem involve use of a repository such as the Commission proposes in the Release, NQB is willing to assist insofar as it reasonably can. NQB is prepared to act as a repository for issuer, market maker and other information. However, NQB must be assured that by doing so it will not become responsible for the content, but only for its provision to others on reasonable, non-discriminatory terms. Thus, NQB request exculpatory provisions shielding repositories from all liability (including content) other than to the issuer and regulators for their gross negligence, willful misconduct and fraud in the providing the information. In short, there should be no responsibility for content under any circumstances and even honest but negligent mistakes in collecting, maintaining and providing the information.
As NQB currently contemplates this role, it would have an information repository for non-reporting issuers. Use by a given issuer would be voluntary, but NQBís contract would require issuers to supply financial information on a timely schedule. NQB would make all information in the repository available to broker-dealer subscribers. The public could access the information through their broker-dealer. NQB would be prepared to place identifiers on the securities quoted in its Pink Sheets and other services identifying whether the issuer was current with the Commission, current with NASD, current with the NQB repository under the standard contract, or not current. Customers would be warned through legends and other materials that securities in the latter category carry especially serious risks. This would serve at least partially to enable the operation of previously suggested rules where issuers, insiders and promoters would not be able to access the marketplace to buy or sell while minority outsiders would still be able to buy or sell their securities with other outsiders in an efficient, competitive and transparent medium.
H. Cut Back Existing Rule
The NQB believes that the existing rule 15c2-11 should be modified. As it has proposed in the Release, the Commission should exempt out all debt securities, securities listed on certain established foreign exchanges, and securities convertible into exempt securities. Confirmed bankruptcy disclosure statements should be made as allowable documentation. These parts of the Proposed Rule have not been controversial and would reduce the current regulatory burden on legitimate market participants. NQB hopes that the Commission can find a prompt means of effecting these non-controversial changes to the existing rule.
NQB further believes that if an issuer is reporting to a regulatory agency, the dealer publishing the initial quote should only need to make sure that the issuer is current in reporting to its regulator. The Commission should remove the requirement that the dealer vouch for the accuracy of documents that have been filed with the Commission or banking and insurance regulators. For non-reporting issuers, the accuracy statement would be better phrased as a legal matter as a double negative, "no material reason not to believe."
NQB further believes that all market makers should disclose to their regulators and any quotation medium in which they publish quotations, any significant relationships to issuers on a continuing basis.
I. Improve the OTC Marketplace
All of the Commissionís regulatory initiatives concerning the secondary markets for small businesses have been driven by enforcement concerns. The time has come for the Commission to review what can be done to improve the secondary market for small businesses. Without a vibrant secondary market, the small business capital formation process is severely impaired. The Division of Corporation Finance has been very cognizant of the need to ease regulatory burdens for the primary issuance of securities. Their Office of Small Business is an important advocate for small businesses. The Division of Market Regulation has no advocate for small businesses and their needs. NQB goes so far as to suggest that the Division of Market Regulation establish an Office of Small Business. It could seek to improve the efficiency, competition and liquidity in secondary markets for small businesses. Much has been done in the higher tiers of the marketplace and now it is time to maximize the potential of what an efficient secondary market for small businesses can do for our economy.
NQB strongly supports all efforts to identify and eradicate fraud in all market sectors.
Chairman Levitt stated in the Commissionís 1996 annual report "Throughout its existence, the Commission has balanced the need for full disclosure and investor protection against the burden that its rules, regulations, and requirements may impose on capital formation." The quandary is that the market for small issuers with low share prices, little or no analyst coverage, thin capitalization and information, consists of two distinct camps, legitimate and illegitimate. The Proposed Rule will impose significant burdens on all of the legitimate issuers, investors and broker-dealers in the covered securities, with little improvement of disclosure or investor protection.
The 1991 release used the reasoning that Rule 15c2-11 should be changed because "Today, the rule applies principally to the non-Nasdaq market, predominantly consisting of infrequently traded, relatively unknown securities with unpriced quotation entries and little or no competition among market makers." Today, the vast majority of OTCBB market maker quotations are two-sided and almost all are priced. NQB expects the Pink Sheets would have the same characteristics when market makers are able to update their quotations on a real-time basis. The Commissionís standard of best execution for a non-Nasdaq OTC security has been three competing quotes. Since the average security has over five market makers NQB wonders if the Commission would today classify them as having little competition?
Investors will suffer from illiquid, opaque OTC markets. Legitimate investors and shareholders will be harmed. Substantial regulatory costs for market makers will be passed on to investors in the form of wider spreads and less liquidity. Competition will diminish, as fewer reputable firms are willing to trade OTC securities. Transparency will decrease, as fewer market makers are willing to publish prices. Some securities may disappear from the public markets.
If implemented, the Proposed Rule will irreparably harm the secondary markets for legitimate small businesses. The cost of capital will rise if there is not an efficient secondary market for small or troubled companies. Legitimate capital sources for small or troubled companies will dry up. Market makers will be less inclined to quote new securities. The good companies are forced to pay for the misdeeds of others.
Our nations capital markets are the envy of the free world. To power our economic growth, regulation must look to improve opportunities for small business to access capital markets so they have an opportunity to become the big businesses of tomorrow. Indeed the Release actually cites injury to the legitimate segment of the market as one of the reasons that the Proposed Rule has been promulgated in an effort to reach the illegitimate part. Yet as this comment has repeatedly pointed out, that will not be the effect of the Proposed Rule. It should not be adopted.
cc:The Honorable Arthur Levitt, Chairman
The Honorable Norman S. Johnson, Commissioner;
The Honorable Isaac C. Hunt, Jr., Commissioner;
The Honorable Paul R. Carey, Commissioner;
The Honorable Laura S. Unger, Commissioner;
Annette L. Nazareth, Director, Division of Market Regulation;
Robert L.D. Colby, Deputy Director, Division of Market Regulation;
Catherine McGuire, Associate Director and Chief Counsel, Division of Market Regulation;
Larry E. Bergmann, Senior Associate Director, Division of Market Regulation;
Belinda Blaine, Associate Director, Division of Market Regulation;
James Brigagliano, Assistant Director, Division of Market Regulation;
Florence E. Harmon, Assistant Director, Division of Market Regulation;
Nancy J. Sanow, Senior Special Counsel, Division of Market Regulation.
Irene A. Halpin, Division of Market Regulation;
Chester A. McPherson, Division of Market Regulation;
Jerome J. Roche, Division of Market Regulation;
Richard Walker, Director, Division of Enforcement;
Elizabeth P. Gray, Assistant Director, Division of Enforcement;
Brian Lane, Director, Division of Corporate Finance;
Richard Wulff, Chief, Office of Small Business, Division of Corporate Finance