David G. Shuldiner
80 West 12th Street
New York, N.Y. 10011-8660
March 16, 1999
Johnathan Katz, Secretary
Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street, N.W.
Washington, D.C. 20549
Release No. 34-41110; File No. S7-5-99
Dear Mr. Katz:
We have been a professional securities analyst for over 40 years and an investor in microcap securities for over 25 years.
Sections V. Effects on Capital Formation and VI. Costs and Benefits of the Amendments contained in the reproposal are so seriously flawed as to question the validity of the entire reproposal. In our view, the proposed changes (when properly calculated) would cause a major increase in costs and would have a significant adverse effect on investment.
Costs: The estimated costs to the dealer broker contained in the reproposal are in error. Firstly, the reproposal assumes that investigating a reporting issuer would require a minimum amount of due diligence (4 hours). As a security analyst dealing primarily with reporting issuers, we do not agree with this premise. Time and time again we find dubious practices in filing companies. Secondly, the cost examples in the reproposal assume that the process of review ends at a date certain and seem to imply that the broker-dealer does not have worry about red flags before the next anniversary. Reading the amendments themselves suggests otherwise. In other words, the broker-dealer will have to read and analyze all information available in an 8K, other filing documents and be aware of information from all possible sources continuously. Thirdly, the reproposal treats the due diligence process to be performed as a clerical exercise comparable to running a database screen and applies a cost off $40 an hour. One only has to review the proposed requirements and the potential liabilities to the broker-dealer to realize this approach is unrealistic.
If a broker-dealer could comply with the proposed amendments, which we think are unworkable, it would have to employ a risk analyst and retain special legal counsel. Such experts charge in the neighborhood of $300 an hour plus reimbursement of out of pocket. It should be possible to employ an acceptable full time in-house analyst at the equivalent of around $150 to $175 an hour. However, to save money by using in-house as opposed to outside special legal counsel would not be feasible in our opinion. We believe that a minimum of due diligence for any listing would be 8 hours, and many listings would require days of work. Our realistic estimate, including continuing follow on coverage, would be 12 hours on average.
The number of review listings subject to the reproposal is likely to be higher than the reproposl's estimate because the Pink Sheets has announced that it is converting from static to real time in the near future. This will result in a greater number of priced quotations. Our guess is that Pink Sheets priced quotations will increase to the same level prevailing for OTBB securities over a period of time.
Using the reproposal's numbers and incorporating our modifications, the costs increase from $5.7 million to $71.5 million per annum. Over and above these immediate costs, the reproposal has not factored in the costs of litigation. Broker-dealers, no matter how carefully they are, will be blind sided and be sued and lose. Litigation is expensive, and the damage awards can be very high.
As indicated above, we think that the reproposal is totally unworkable. The proposed regulations therein are confused, vague and contradictory and create a huge legal exposure for the broker-dealer. As a result, we think that the dealer microcap market will be destroyed. This may not happen immediately. More likely, the melt down will occur when a broker dealer loses the landmark "deep pocket" lawsuit arising from the proposed changes.
Nowhere in the reproposal is any consideration given to such a scenario occurring and to the resulting costs to investors other than the victims of microcap fraud activities. Surely, the destruction of the dealer microcap market is going to cost investors' money and would make it extremely difficult for investors to take tax losses. No dealer market means opaque markets and lower prices. Extrapolating from OTBB and Pink Sheets data, the relevant annual volume of microcap securities appears to aggregate $27 billion. Based on our discussions with knowledgeable broker-dealers and based on our experience, the absence of a dealer market would cause a minimum 10% reduction in price realization. This is a very conservative assumption given the fact that low price stocks are quoted at larger percentage spreads. Thus, investors will incur an added cost of $2.7 billion per annum.
Capital Formation: The reproposal states: "the reproposal should have a beneficial impact on capital formation because microcap fraud ultimately increases the costs of raising capital for legitimate smaller issuers. Investors may be less willing to commit their resources if they are concerned about fraudulent activities in OTC securities." We don't agree. It will be much more costly for microcaps to raise capital if the dealer market for microcaps disappears. No dealer market means no transparency, much lower bids and offers, and, most importantly, a complete lack of investor interest. Microcaps needing to raise money may have no recourse but to sell out to the financing source. This does not bode well for the entrepreneurial business model.
Finally, nowhere in the reproposal is any consideration given to another type of capital formation that would be destroyed by the reproposal. Contrary to reproposal's view that spin offs, shells and related assets and tax benefits are dirty words associated purely with microcap fraud, a part of the microcap market is a cauldron for recycling assets into new capital formation. In this specific area of the microcap market, there are hundreds of millions of dollars of salvageable assets awaiting recycling. Very smart people work very hard to convert these assets into liquid capital and earning power. By way of example, two asset recycling exercises that have worked out on an exceptional basis are Leucadia which arose from the James Talcott shell and Vornado Realty Trust from the Two Guys from Harrison disaster.
Benefits: The reproposal states that the benefit of the proposed changes would be the reduction of microcap fraud but has withheld empirical data concerning the amount that defrauded investors would save. Before causing huge increases in costs and billions of losses to investors, it is appropriate to request that the SEC quantify the savings to defrauded investors. It is our speculation that such savings (benefits) would represent only a small percentage of the costs.