[letterhead: Charles Schwab & Co.]
June 3, 1999
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549
Re: File No. S7-5-99
Dear Mr. Katz:
Charles Schwab & Co., Inc. ("Schwab") and its affiliate, Mayer & Schweitzer, Inc. ("MASH") submit this letter in response to the Commissionís reproposed amendments to Rule 15c2-11. Schwab is the second-largest U.S. broker-dealer in terms of active customer accounts and the largest broker-dealer in the world in several important market segments, including electronic brokerage. MASH is a leading Nasdaq market maker and also makes markets in selected OTC Bulletin Board and Pink Sheet securities.
As a broker executing customer orders in thousands of micro-cap securities, and as a market maker in hundreds of the more actively traded micro-cap securities, Schwab and MASH share the Commissionís commitment to promoting investor confidence in this segment of the market. While this market can offer diligent investors substantial opportunities for growth, micro-cap securities can sometimes be susceptible to unscrupulous sales practices by a small but persistent group of dishonest individuals and firms employing high-pressure sales tactics and false or exaggerated claims to market their "house stocks." This activity threatens the interests of investors and harms every legitimate issuer and broker-dealer in the process. In fact, legitimate market makers themselves invariably become victims of these "pump-and-dump" schemes when a manipulation collapses and the market maker is left holding the security in inventory.
Consistent with the findings of Congress in 1990 in addressing fraud in the trading of penny stocks, we believe that an active and transparent market is one of the most effective deterrents to fraud and manipulation. We therefore have serious reservations about the Commissions proposal to the extent it would discourage active market maker participation and the use of priced quotations. While well intentioned, this proposal would have the paradoxical effect of increasing the incidence of fraud in micro-cap securities by reducing the transparency and efficiency of the marketplace.
Although we have serious concerns about the particular approach suggested by the Commission with these proposed amendments, we nevertheless strongly agree about the need for further steps to address micro-cap fraud. Based on our experience in this marketplace, we have identified a number of regulatory and industry initiatives that we believe would be effective in combating manipulation and abusive sales practices. These suggestions are presented in the latter part of this letter.
A. The Vital Importance of Transparency to Fair and Efficient Markets
Congress and the Commission have long recognized transparency as the cornerstone of fair and efficient markets. For example, in addressing abuses and inefficiencies in the OTC market in its 1963 Special Study of the Securities Markets, the Commission recommended the development of an automated interdealer quotation system for the dissemination of quotation information "to permit the immediate identification of the highest bid and lowest offer, and thus facilitate the task of a broker-dealer in obtaining the best market for his customer," and for "surveillance or study purposes by the Commission and other regulatory bodiesÖ." Likewise, transparency of price information was a central underpinning of the 1975 National Market System amendments and the Commissionís 1996 Order Handling Rules, and underlies current initiatives within Congress and by the Commission to improve the fairness and efficiency of the bond market.
In the micro-cap market in particular, legislators and regulators have consistently stressed the importance of transparency as a tool to combat fraud. Indeed, in 1990 Congress explicitly recognized a direct correlation between the lack of transparent and reliable quote information for penny stocks and the incidence of fraud and manipulation:
Because it is wrapped in secrecy and operates in relative obscurity, the penny stock market lends itself to manipulation far more easily than a market where information is readily available and circulated to investors. Penny stocks are often thinly traded and this more readily facilitates control and domination by a single market maker. The securities thus become attractive vehicles for manipulative, artificial schemes which are intended to raise the price or volume of the securities, primarily for the benefit of the few anonymous insiders, and frequently, the brokerage firm itself, which often unloads its own shares of the stock into the market after it has manipulated the price of the stock skyward.
Emphasizing the importance of transparency to combating fraud, Congress therefore directed the Commission to facilitate the widespread dissemination of reliable and accurate quotation information for penny stocks through the establishment of one or more automated quotation systems. Specifically, Congress found that
Developed in accordance with this Congressional mandate, the NASDís OTC Bulletin Board Service has been effective in curbing abuses in penny stocks by increasing the visibility, fairness and efficiency of the market and strengthening the NASDís ability to monitor trading. Similar transparency benefits are expected for securities quoted in the Pink Sheets when the National Quotation Bureau launches its online version of the Pink Sheets this summer. This system, which will feature real time prices displayed electronically and ranked in order of best bid or offer, will substantially increase the transparency and liquidity for OTC securities now traded in the Pink Sheets, which in turn will make it more difficult for unscrupulous firms to dominate and control the market for a micro-cap security.
B. The Reproposed Amendments to Rule 15c2-11
As discussed in our comment letter on the Commissionís initial proposal, requiring market makers to certify to the accuracy and reliability of issuer disclosure information would impose substantial and expensive compliance burdens on market makers and expose these firms to the threat of costly litigation. Although the Commissionís reproposal attempts to narrow the application of the proposed amendments to less actively traded micro-cap securities, our concerns with the original proposal remain the same. We note that the reproposalís carve-out of actively traded and larger capitalized securities does not significantly narrow the scope of the original proposal, and as a fundamental matter, we continue to be concerned about the likely negative impact of the proposed requirements on transparency, pricing efficiency and investor protection.
1. The Reproposed Amendments Run Contrary to the Interests of Investors in a Fair and Efficient Market
The additional compliance costs and increased liability for market makers under the Commissionís proposal will discourage legitimate firms from making markets or displaying priced quotations in micro-cap issues. Given the infrequent trading activity in most micro-cap securities, market maker liquidity is critical to ensuring a fair and orderly market. In the non-Nasdaq OTC market, well-priced standing limit orders are infrequent, and market makers play a vital role as a temporary provider of liquidity while finding the natural other side for an order. To the extent that the proposed requirements would discourage the use of priced quotations or lead firms to cease making markets in certain securities entirely, the proposed requirements would reduce transparency and lead to wider spreads in a segment of the market where liquidity is already limited.
Reduced liquidity and transparency will make it more difficult for firms to find the best prices for customer orders. It is well established that transparency of market interest facilitates price discovery and promotes market efficiency. Limiting the use of priced quotations would force firms to obtain prices over the telephone and handle more orders manually, thereby increasing the difficulty of obtaining best execution for customer orders. Our own experience bears this out. As trading volumes in OTC Bulletin Board and Pink Sheet securities have swelled, we have invested heavily in automation to handle the increased order flow. Without efficient access to transparent and reliable quotes, we will be forced to handle these orders on a manual basis, which will substantially slow down the process and dramatically increase the cost of executing orders. Without ready access to price information, investors will also find it harder to compare prices and assess the quality of their executions.
Particularly troubling is the fact that reduced liquidity and transparency would make the market for micro-cap securities more susceptible to manipulation. The equilibriating influence of independent market makers in a security impedes the ability of unscrupulous firms to manipulate trading interest and prices. In the absence of the visible prices and liquidity supplied by legitimate market makers, it will be easier for unscrupulous firms to dominate and control the market for a micro-cap security. Worse, the loss of transparency would undermine SRO surveillance efforts by making it harder for regulators to monitor for unusual market activity.
We are also concerned that the Commissionís proposal would impair capital formation for those issuers (small businesses) most in need of efficient, low cost access to capital. The micro-cap market provides an important source of capital for these nascent companies. Typically, venture capitalists and other investors in these companies depend on the liquidity and pricing mechanism of multiple competing market makers as an outlet for realizing the value of their investments down the road. Because such investors will not commit capital without an exit strategy, the existence of a liquid market is critical to the ability of micro-cap companies to raise capital to finance growth. It is also worth noting the importance of the OTC Bulletin Board and Pink Sheet markets to companies in the midst of bankruptcy proceedings that have been delisted from Nasdaq and the exchanges. An active market and reliable, transparent pricing for these securities during bankruptcy facilitates their reorganizations and provides a foundation for such companies to emerge from bankruptcy.
While we support the Commissionís efforts to address fraud in the micro-cap market, the approach proposed here by the Commission would appear to jeopardize market liquidity for the shares of these companies, undermine their ability to raise capital, and hinder the ability of shareholders in these companies to value and trade their positions. Overall, the proposed amendments represent a very real danger that thousands of micro-cap companies will be forced from the OTC Bulletin Board and Pink Sheets, where participants are regulated by the Commission and NASD, into less transparent markets and less regulated markets on the Internet or overseas. In considering abusive practices in the micro-cap market, we urge the Commission to avoid damage to an important market for the securities of legitimate small companies, particularly since the NASD has recently made it more difficult for small companies to be listed on Nasdaq or traded on the OTC Bulletin Board.
Requiring market makers to certify to the accuracy and reliability of issuer disclosure information will not prevent fraud. Because market makers are not well suited to detect fraud or manipulation, we believe the amendments would bring little if any corresponding increase in the detection or prevention of fraud. Market makers have comparatively far less ability to identify potential financial fraud or going concern issues than, for example, the issuerís independent auditors, who have unrestricted access to the issuerís books and records, and are thus in a better position to review issuer disclosures for red flags or other evidence of fraud. Indeed, notwithstanding their familiarity with the issuer, public auditors themselves often have considerable difficulty in uncovering issuer fraud.
Furthermore, the Commissionís assumption that the quotations of legitimate market makers can indirectly facilitate a fraud fundamentally misconstrues the function market makers perform in the marketplace. The Commissionís reproposal essentially equates market maker quotes with recommendations, yet fails to explain how the harm it identifies (fraud and manipulation) is related to publication of quotes by market makers who are not involved in the fraud. While the Commissionís initial proposing release states that market makers can give a security "a measure of credibility through their quotations," we are not aware of any evidence that investors or the marketplace generally view market maker quotations as a representation about a securityís investment value.
To the contrary, it is generally understood that market maker quotes reflect only the value the market ascribes to the security (rather than the market makersí view of what the security may be worth based on analysis of the companyís fundamentals). Market maker quotes are a function of market interest and the interplay of supply and demand. Market makers do not trade with a view to whether the security represents a good or bad investment. The existence of market maker quotes in a security is no more a recommendation or indication of credibility than a newspaperís publication of a classified advertisement. Instead of focusing on legitimate market makers, the Commission should focus on those who disseminate false information about issuers and thereby distort the market interest that legitimate market makersí quotes reflect.
In our experience, an effective program to combat abusive and fraudulent practices in the micro-cap market must combine the following essential elements: (1) increased scrutiny of abusive sales practices; (2) increased accessibility of issuer disclosure information; and (3) increased transparency of secondary market trading.
1. Increased Scrutiny of Broker Sales Practices
In casting market makers as gatekeepers for screening out illegitimate companies from the OTC Bulletin Board and Pink Sheets, the Commissionís proposal fails to address the primary source of abuses in the micro-cap market Ė fraudulent sales practices by unscrupulous firms and individuals. The modus operandi for these frauds is all too familiar: misrepresentations and omissions, aggressive high-pressure sales practices, unsuitable recommendations, churning, unauthorized trading, failure to respond to customer complaints, and refusal to execute customersí orders to sell "house stocks." The effort to combat micro-cap fraud therefore should start with increased regulatory scrutiny of broker sales practices in connection with solicited transactions.
We note that the Commission is currently considering a proposed NASD rule change that would require members and their associated persons to review reasonably current financial statements of an issuer prior to recommending a transaction to a customer in a non-Nasdaq OTC security. We believe this proposal is better tailored to address the principal hazard in this market Ė aggressive cold-calling by broker-dealers telemarketing "house stocks." Under SRO rules and the antifraud provisions of the federal securities laws, a broker who recommends a security to a customer must have a reasonable basis for that recommendation, which naturally requires that the broker have sufficient information about the security. Although that suitability analysis focuses in large part on the brokerís knowledge of the customerís financial status and objectives, it also requires the broker to have a reasonable belief in the accuracy and reliability of the issuer disclosure information on which its recommendation is based. Explicitly applying this review obligation to brokers recommending securities would be a highly effective deterrent to fraudulent promotions of "house stocks" and would provide regulators with ample authority to crack down on abusive sales activity.
Increased Regulatory Surveillance and Enforcement
No regulatory solution to abuses in the micro-cap market will be as effective as vigorous surveillance and enforcement of the existing antifraud provisions. Instead of allocating scarce enforcement resources to ensuring compliance with the proposed market maker review requirement, the Commission and other regulators should be devoting their resources to surveillance for abusive sales practices and manipulation. Regulators must have the surveillance tools to respond rapidly to unusual trading activity and other indications of suspected fraud, and the enforcement resources to aggressively prosecute violations. We would also encourage the Commission and the SROs to expel and permanently bar from the securities industry those firms and individuals who engage in manipulation schemes, including not only the leaders of these schemes but also the sales people who defraud customers. The Commission and the SROs should focus on rapid prosecution of these schemes, rather than waiting to bring cases many years later. Because civil sanctions may not always be effective against these types of firms and individuals, we encourage the Commission and the SROs to seek the assistance of criminal prosecutors in addressing this type of fraudulent activity.
2. Increased Accessibility of Issuer Information
The Commission should take steps to increase the availability of issuer disclosure information, and facilitate initiatives designed to inform investors about the completeness and timeliness of available issuer information.
The Commission should facilitate the development of a central information repository for non-reporting companies. The repository could be funded through a combination of issuer and industry support, with issuer disclosure information made publicly available through the Internet or an 800 number. Although some of this disclosure information may have to be delivered to the repository by issuers directly, we note that NASDR already receives Form 211 submissions for all securities trading on the OTC Bulletin Board and Pink Sheets and thus could provide issuer disclosure information directly to the repository. A central repository would also be considerably more efficient than the current situation under Rule 15c2-11 in which each market maker in a security must separately maintain issuer disclosure information in its files. At the same time, a central repository with Internet or 800 number access would make issuer information far more accessible to individual investors than would requiring investors to contact different market makers to obtain that information.
As a deterrent to fraudulent sales by corporate affiliates, the Commission should limit the ability of corporate insiders to trade in the public marketplace when sufficient current information is not publicly available. We believe this would be an effective mechanism to achieve the Commissionís goal of increasing the availability of issuer information. Insiders would be expected to maintain current filings with the Commission (for reporting companies) or ensure that current disclosure information was available through a repository.
The Commission should consider requiring the use of a special symbol in connection with issuers quoted on the OTC Bulletin Board and Pink Sheets that are non-reporting companies or that are not current in their regulatory filings. Broker-dealers would be required to convey that information to customers when recommending securities or providing a quotation.
Affiliations with the Issuer
Brokers recommending a security to their customers or making markets in a security should be required to disclose any affiliation they may have with the issuer. Brokers should be required to report such affiliations to customers prior to recommending a security. Market makers should be required to indicate such affiliations through the use of a special symbol attached to their OTC Bulletin Board or Pink Sheet quote.
The Commission should consider ways to facilitate the development of ratings by established national rating services concerning the completeness of issuer disclosure information as well as the existence of certain internal control and governance issues (e.g., independent auditors, constitution of audit committees, public board members). These ratings would assist investors in evaluating the reliability of issuer disclosure information.
Expanded Authority to Impose Trading Halts
Although the NASD monitors trading in non-Nasdaq OTC securities, the NASD lacks the authority to suspend trading when fraud is suspected. The NASD should have expanded authority to impose trading halts in circumstances where regulators have reasons to suspect manipulation or dissemination of inaccurate issuer information for non-Nasdaq OTC securities. We would also support the Commissionís expanded use of trading halts for suspicion of manipulative activity in a security or incomplete or out-of-date information about an issuer.
Consistent with the findings of Congress in addressing penny stock fraud, we believe that transparency of secondary market trading interest is critical to preventing fraud, both as a natural deterrent to manipulation and as a surveillance tool for regulators.
Electronic Pink Sheets
The automated version of the Pink Sheets that is being developed by the National Quotation Bureau will substantially increase the market transparency and liquidity of OTC securities now traded in the Pink Sheets by providing a real-time, dynamic mechanism for the dissemination of market maker quotations. We encourage the Commission to facilitate the development of this system, and to consider ways to build on the existence of this system to advance the Commissionís goals, such as through sponsorship of a central repository.
The NASD should expand the scope of its new Order Audit Trail System ("OATS") to include transactions in non-Nasdaq OTC securities, thus enabling NASDR to identify firms that are soliciting transactions in securities with unusual volume or price volatility. As part of this audit trail, broker-dealers should be required to report to the NASD with each trade report, the bid and ask prices prevailing on the OTC Bulletin Board or Pink Sheets at the time of execution.
While we commend the Commission for its efforts to combat abuses in the market for micro-cap securities, we have serious concerns about the likely impact of the reproposed amendments on market integrity and efficiency. Because of the importance of transparency to a fair and efficient market, particularly with respect to micro-cap securities, we urge that the Commission consider a more tailored approach to address abusive practices by the handful of problem firms and individuals responsible for micro-cap fraud. Transparency of price information is a proven deterrent to manipulation, both as an impediment to domination and control of trading interest by unscrupulous firms, and as a critical surveillance tool for regulators. Transparency promotes competition, increases liquidity and reduces transaction costs. Transparency also makes possible important automation efficiencies for disseminating market information to customers and executing customer orders. By discouraging the use of priced quotations, the Commissionís proposal would undermine the transparency and liquidity of trading in micro-cap securities without any corresponding increase in the detection or prevention of fraud. The small group of dishonest firms and individuals responsible for micro-cap fraud are violating existing rules. Imposing a de facto listing review obligation on market makers with no relation to the issuer and no connection to the fraud will not prevent these abuses.
Given our shared interest in the integrity of this market, we are committed to assisting the Commission develop effective responses to micro-cap fraud and hope you will find our experience and suggestions useful in this regard. Please do not hesitate to contact us if you would like to discuss these issues in further detail.
/s/ Lon Gorman
Executive Vice President
cc: Hon. Arthur Levitt, Chairman
Hon. Norman Johnson, Commissioner
Hon. Isaac C. Hunt, Jr. Commissioner
Hon. Laura Simone Unger
Hon. Paul R. Carey, Commissioner
Annette Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Larry Bergmann, Senior Associate Director, Division of Market Regulation
James Brigagliano, Assistant Director, Division of Market Regulation
Florence E. Harmon, Special Counsel, Division of Market Regulation
Richard Walker, Director, Division of Enforcement
Elizabeth Gray, Assistant Director, Division of Enforcement
Richard Ketchum, President, NASD
Mary Schapiro, President, NASD Regulation, Inc.
S. William Broka, Senior Vice President, The Nasdaq Stock Market