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U.S. Securities and Exchange Commission

1998 Conference on Federal-State Securities Regulation Final Report

North American Securities Administrators Association, Inc.
U.S. Securities and Exchange Commission
1998 Conference on Federal-State Securities Regulation
Final Report

North American Securities Administrators Association, Inc.
10 G Street, N.E.
Suite 710
Washington, D.C. 20002

U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

October 1998

Table of Contents

I. Summary 3
II. Reports of the Working Groups  
  A. Corporation Finance 5
  B. Investment Management 16
  C. Market Regulation 19
  D. Enforcement 25
III. Exhibits  
  A. Commenters 40
  B. NASAA and SEC Representatives 41

I. Summary

The United States Securities and Exchange Commission ("SEC" or "Commission") and the North American Securities Administrators Association, Inc. ("NASAA") held their annual meeting in Washington, D.C. on May 4, 1998. This year's meeting was the fifteenth meeting held under Section 19(c) of the Securities Act of 1933. Under that Section, the SEC must hold an annual meeting to:

  • maximize uniformity in federal and state securities regulation;
  • maximize effectiveness of regulation;
  • reduce costs and paperwork for issuers; and
  • minimize interference with capital formation.
The 1998 meeting was the second meeting following passage of The National Securities Markets Improvement Act of 1996 ("NSMIA"). NSMIA contains significant provisions that realign the regulatory partnership between federal and state regulators. That law reallocates responsibility for regulation of the nation's securities markets between the federal government and the states in order to eliminate duplicative costs and burdens and improve efficiency, while preserving investor protections.

Before the meeting, the SEC and NASAA solicited the views and comments of interested parties for consideration by conference participants. Three parties provided written comments. These comments provided useful information for discussion at the meeting.1

Approximately 60 representatives from the states and from the SEC attended the 1998 meeting.2 Participants divided into four working groups in the following subject areas: corporation finance; investment management; market regulation and enforcement. SEC and NASAA representatives discussed matters of common interest and concern in the working groups. A description of the discussions of each group is set forth in Part II. of this report. During the working groups, participants outlined current state and federal regulatory efforts and initiatives. They identified areas where joint cooperation would be beneficial and discussed ideas and plans for more effective cooperation, coordination and communication.

II. Reports of the Working Groups

A. Corporation Finance

1. Uniformity of Regulation

NSMIA amended Section 18 of the Securities Act of 1933 ("Securities Act") to preempt state blue-sky registration and review of securities offerings of "covered securities." "Covered securities" are defined by the same Section and include several types of securities, including "nationally traded securities," i.e., securities traded on the New York Stock Exchange, Inc. ("NYSE"), American Stock Exchange, Inc. ("Amex") or the Nasdaq National Market System ("Nasdaq/NMS"). "Covered securities" also include registered investment company securities and certain exempt securities and offerings.

Securities that are not "covered securities" remain subject to state registration requirements. These securities include:

  • securities quoted on the Nasdaq SmallCap market or the National Association of Securities Dealers, Inc.ís ("NASD") over-the-counter Bulletin Board ("OTC Bulletin Board");
  • securities quoted on the over-the-counter ("OTC") "pink sheets";
  • securities listed on securities exchanges other than the NYSE or Amex;3
  • various securities of non-listed issuers, such as asset-backed and mortgage-backed securities;
  • private placements of securities under Section 4(2) of the Securities Act that do not meet the requirements of Rule 506 of Regulation D; and
  • securities issued in exempt offerings under Regulation A and Rules 504 and 505 of Regulation D.

The states retain certain authority in connection with offerings of covered securities. With respect to these offerings (other than nationally-traded securities), the states have the right to require specified fee payments and/or notice filings. The states also retain anti-fraud authority over all securities offerings, including offerings of covered securities. The statesí authority over securities offerings continues the need for uniformity between the federal and state registration systems, where consistent with investor protection.

NSMIA required the Commission to conduct a study about the extent of uniformity among state regulatory requirements for securities and securities transactions that are not "covered securities" (the "Uniformity Study"). The Commission issued the study results in its "Report on the Uniformity of State Regulatory Requirements for Offerings of Securities that are not ĎCovered Securitiesí" in October 1997 (the "Uniformity Report"). The SEC distributed survey questionnaires to various interested parties, including the state securities administrators. Forty-six states responded to the questionnaires. The SEC thanked the states for their many valuable responses to the survey. The group discussed the Uniformity Report, the nature and extent of uniformity at present, and methods to increase uniformity.

2. Definition of Qualified Purchaser and Accredited Investor; NASAAís Model Accredited Investor Exemption

Section 18 of the Securities Act, as amended by NSMIA, excludes from state registration and review securities offerings to purchasers who are defined by the Commissionís rules to be "qualified purchasers." A security sold to a "qualified purchaser" is a "covered security" subject to the same regulatory approach as other covered securities. The SEC is working on a definition of "qualified purchaser" for this purpose. In this process, the Commission is considering whether changes should be made to the definition of "accredited investor" under the Securities Act, and whether the definitions of "qualified purchaser" and "accredited investor" should be similar or different.

The SEC described the status of the qualified purchaser rule-making project. The staff indicated that it is considering proposing a definition based on the level of "investments" held by an investor and proposing the same definition for both qualified purchaser and accredited investor. SEC and NASAA representatives discussed the appropriate criteria for the two definitions, such as whether an investment test would be suitable and the appropriate level of investments under such a test.

The group also discussed NASAAís Model Accredited Investor Exemption which was adopted in 1997. The model rule exempts offers and sales of securities from state registration requirements if, among other things, the securities are sold only to persons who are, or are reasonably believed to be, accredited investors. NASAA reported that 11 states had adopted the exemption, and several others intended to adopt the exemption in the near future or were considering adoption. The states asked the SEC to consider adopting a federal exemption that would coordinate with the accredited investor exemption. The participants discussed the effect on the state accredited investor exemption if the SEC ultimately adopts a qualified purchaser definition that is the same as or similar to the accredited investor exemption.

3. Small Business Initiatives

The conferees discussed the SECís proposed amendments to Rule 430A to permit certain smaller or less seasoned reporting companies to price securities on a delayed basis after effectiveness of a registration statement, if they meet specified conditions.4

The Commission proposed revisions to Rule 701 under the Securities Act shortly before the conference.5 Rule 701 provides an exemption from registration under the Securities Act for the offer and sale of securities to employees and certain other persons by private companies under compensatory benefit plans or written compensation agreements. The proposals are designed to expand the ability of issuers to use the Rule, improve the disclosures provided in offerings under the Rule and clarify and simplify the Rule. For example, the proposals would remove the current limitations based on offers and instead focus only on the amount of sales permitted each year. Issuers would be allowed to sell securities each year up to an amount determined under two formulas (i.e., 15% of total assets or 15% of outstanding securities) or $1 million, whichever is greater. The present $5 million limitation on the aggregate offering amount would be removed from the Rule. Rule 701 now does not impose any specific disclosure obligations on the issuer. The proposed Rule revisions would require disclosure of risk factors and the unaudited financial statements required in a Regulation A offering.

The participants discussed the comment letters received on the Rule 701 proposal. The SEC reported that commenters have indicated that issuers do not want mandated disclosure requirements. The commenters have argued that smaller offerings should be exempted from specific disclosure requirements, if any are adopted. Respondents also represented that Rule 701 is used for inadvertent sales to employees. They asserted that the rule would no longer be available for those sales if a specific disclosure requirement is adopted.

Both federal and state regulators expressed the understanding that disclosure is being provided in Rule 701 offerings, even though the Rule does not require specific disclosure. They thought that the anti-fraud provisions of federal and state laws would require disclosure of information material to an investment decision.

Commission and state representatives discussed several issues under the Regulation D exemptions. Rule 506 of Regulation D provides a "safe harbor" for non-public offerings under Section 4(2)of the Securities Act. An issuer which satisfies the requirements of Rule 506 can be assured that its offering will qualify as a non-public offering under Section 4(2).6 As noted above, securities issued in a Rule 506 offering are covered securities and preempted from state registration requirements. Some states expressed concerns that the disclosure provided in certain Rule 506 offerings may not provide full information about past disciplinary or enforcement proceedings against promoters or management. The states asked the SEC to consider adding a "bad-boy" provision to Rule 506, similar to the one in current Rule 505.

Rule 504 of Regulation D provides an exemption from the Securities Act registration requirements for offerings up to $1 million in any 12-month period, if certain conditions are met. Generally, Rule 504 is available only to the smallest companies. Issuers in Rule 504 offerings may use general solicitation or advertising, and the securities issued in those offerings are freely tradeable. Rule 504 offerings are not subject to specific federal disclosure requirements and these offerings are not reviewed at the federal level.

The SEC is concerned that this current federal approach to Rule 504 offerings may be contributing to fraudulent offerings by micro-cap issuers, i.e., issuers with small amounts of capitalization, or fraudulent aftermarket trading in securities of micro-cap issuers on the OTC Bulletin Board or in the "pink sheets." Commission and state representatives discussed whether and how Rule 504 should be revised to address these fraud concerns, while at the same time preserving the ability of small companies to raise capital. The SEC reported that it is considering whether to propose restricting all securities issued in Rule 504 offerings, regardless of whether the offering is registered with any state.7

Conferees discussed several state initiatives designed to facilitate offerings by smaller issuers. These initiatives include:

  • the Coordinated Equity Review ("CER") program;
  • the Small Company Offering Registration ("SCOR") form; and
  • the state regional review program for SCOR and Regulation A filings (the "Regional Review Program").

The CER program provides for a coordinated state review process for offerings of equity securities registered at the federal level. Under CER, the participating states coordinate with each other to produce one comment letter to an issuer which addresses both substantive and disclosure matters. NASAA reported that 46 states participate in the program and that 20 securities offerings had been processed under the program. The states try to issue the first comment letter in 12-15 days of receipt of the filing. The states indicated that issuers and securities lawyers that have participated in the CER program have voiced positive feed-back.

Many states use a similar coordinated program to review state registrations using the SCOR form, the "Regional Review Program." The SCOR form is a simplified question and answer format used for the registration of securities offerings with approximately 40 states. This form is used to register securities offerings exempt from registration under Rule 504 of Regulation D or Regulation A at the federal level. Under the Regional Review Program, states in certain regions of the country elect one state to lead the review and issue comments on the filing. Three regional programs have been started to date and include about one-half of the states requiring registration of these offerings.

The SCOR form was adopted by NASAA in 1989. The states reported that the SCOR form was under revision to update it for changes since 1989 and to reflect experiences with the form. They asked the SEC to amend Form 1-A to include the revised SCOR form, when adopted.

4. Securities Act Reform Project

The Commission has been engaged in a broad reexamination of the regulatory framework for the offer and sale of securities under the federal securities laws. The SEC indicated that a release should be published soon that would propose many significant changes. The proposal would address, among other matters, communications before and during the offering period, integration issues between private and public offerings and the timing of disclosure under the Securities Exchange Act of 1934 ("Exchange Act").

5. Plain English

On January 22, 1998, the Commission adopted rule amendments that require the use of plain English writing principles when drafting the front part of prospectuses, namely, the cover page, summary and risk factors sections of these documents. These principles include: active voice; short sentences; everyday language; tabular presentation or "bullet lists" for complex material, if possible; no legal jargon or highly technical business terms; and, no multiple negatives. This change became effective October 1, 1998. The group discussed the plain English initiative, including federal and state coordination needed to facilitate the initiative.

6. Electronic Delivery of Disclosure Documents

The participants discussed the impact of electronic technology on the capital formation process and issuer communciations with its security holders. They considered the nature and extent of regulatory changes to accommodate the use of that technology in securities offerings. The SEC reported two recent concerns. First, the SEC has taken a position that would allow the use of the Internet in offshore Regulation S offerings while a private offering is being conducted in the U.S., if certain conditions are met. The SEC asked the states whether the publicly available Internet site would raise general solicitation issues under state laws. Second, with respect to proxy voting over the Internet, the SEC indicated that some state corporation codes may require signatures for proxies. The SEC asked the states to reconsider the need for this requirement because it seems to frustrate Internet proxy voting.

7. Registration of Securities on Form S-8

Form S-8 is an abbreviated registration statement form under the Securities Act used to register the securities of an issuer to its employees in a primarily compensatory context. Form S-8 was expanded in 1990 to make the form available for offers and sales of securities to consultants and advisors who render bona fide services to the issuer if those services are not rendered in connection with offers or sales of securities in a capital-raising transaction. Since that change, the Commission has become aware of the improper use of the form to distribute securities to the public. To address this abuse, the Commission has proposed, among other changes, to expand the form requirements to provide that the services rendered by a consultant or advisor must not directly or indirectly promote or maintain a market for the issuerís 8

The SEC described the 15 comment letters received on this proposal before the conference. The comment letters have asserted that the "promotional" concept is vague and therefore the proscribed activities would be unclear. Commenters have said that increased disclosure about consultants may adversely impact an issuerís business and that the changes would frustrate the ability of issuers to compensate bona fide consultants.

8. Year 2000 Disclosure Issues

The Commission published Staff Legal Bulletin No. 5 in October 1997 (revised in January 1998) which addresses the disclosure requirements of companies facing electronic problems caused by the Year 2000.9 The statement contains the Commissionís views concerning companiesí disclosure obligations about anticipated costs, problems, and uncertainties associated with this issue. The group discussed the disclosure issues raised by Year 2000.

B. Investment Management

1. Adviser Regulation Transition

Representatives of the Commissionís Division of Investment Management ("Division") briefed participants on the status of the division of investment advisers between state-registered advisers and SEC-registered advisers as provided for by the Investment Advisers Supervision Coordination Act ("Coordination Act"), a part of NSMIA. The Coordination Act amended the Investment Advisers Act of 1940 ("Advisers Act"), in part, to reallocate the responsibility for regulating investment advisers between the Commission and the state securities authorities. The Division representatives advised the conferees that most registered advisers had filed the necessary form, Form ADV-T, to indicate whether they were eligible for continued SEC registration or, if not, to withdraw from SEC registration. The registrations of the approximately 5,000 SEC-registered advisers that did not file Form ADV-T are subject to cancellation.10 The Division representatives advised that they would make the list of advisers whose registrations have been canceled available to NASAA.

2. Inspection and Examination Issues

Representatives of the SECís Office of Compliance Inspections and Examinations ("OCIE") discussed continuing coordination with the state securities authorities with respect to inspections of advisers that change from SEC registration to state registration and with respect to enforcement matters. Conferees discussed procedures for sharing information about advisersí past deficiencies and for making referrals of complaints received by one securities regulator about an adviser registered with another securities regulator. The conferees also discussed the importance of determining whether an adviser should be registered with the SEC or a state during the course of an examination of an adviser. The OCIE representatives advised that their inspections would carefully consider issues of eligibility for SEC registration and recommend enforcement action in appropriate cases.

OCIE representatives also reported that the SEC was seeking to streamline the procedure for making inspection information available to the states. The SEC expects to propose a single, uniform access agreement that would replace the various memoranda of understanding it currently has with the different states.

3. State Legislation, Rule-making, and Related Adviser Activities

NASAA representatives reported that 40 states had enacted legislation or adopted rules in response to the Coordination Act. NASAA recently conducted a survey of state adviser regulation activities, and NASAA representatives reported that, as of today, 26 state securities authorities had responded to the survey and these states indicated that they had conducted 614 audits of state-registered advisers, issued 386 deficiency letters, instituted 25 formal actions, and initiated 149 investigations. These state authorities also instituted 13 criminal actions, made 7 criminal referrals, and obtained $173,000 in restitution.

NASAA representatives also reported that NASAA had approved two new uniform rules, one covering books and records and the other revising the definition of investment adviser representative.

4. SEC Rule-making Projects

The conferees discussed pending SEC rule-making involving investment advisers. These rules would allow advisers to register with the SEC that would otherwise be required to register in 30 or more states, would allow supervised persons to advise a number of accommodation clients without being considered an investment adviser representative, and would revise the conditions under which an adviser could receive performance fees. The Division representatives reported that comments had been received on the proposed rules and that final rules were expected to be announced in the near future.

The conferees also discussed future rule-making initiatives. The Division representatives advised that future proposals were likely to include revisions to the custody rule, revisions to the books and records rule, and possible modifications to the requirements for conducting principal trades. The conferees noted the need for consistent federal and state rules to accommodate advisers that switch from one regulatory system to the other.

5. Form ADV -- Electronic Filing Project

The conferees discussed the progress of the joint SEC/NASAA project to establish an electronic federal and state adviser registration system and to revise Form ADV.

6. Examinations of Investment Adviser Representatives

Representatives of NASAA reported that NASAA is developing an entry level examination for investment adviser representatives. It is hoped that the examination will be ready for individual state approval by the end of the year.

C. Market Regulation

1. NSMIA: Broker-Dealer Books and Records

Section 103 of NSMIA prohibits any state from imposing broker-dealer books and records requirements that are different from or in addition to the Commissionís requirements. In addition, the same Section directs the Commission to consult periodically with state securities authorities concerning the adequacy of the Commissionís requirements. The Commissionís current proposal to amend Rules 17a-3 and 17a-4 originated in discussions between NASAA representatives and the Commission about the adequacy of the existing broker-dealer books and records requirements.11 The proposed amendments clarify, modify and expand the Commissionís record-keeping requirements with respect to purchase and sale documents, customer records, associated person records, customer complaints, and certain other matters. In addition, the proposed amendments specify certain types of books and records that broker-dealers must make available in their local offices. The participants discussed the proposed amendments and the comments received, and in particular the definition of "local office" used in the proposed amendments. They also discussed possible revisions to the proposed amendments.

2. Bank Securities Activities

In 1996, the NASD submitted a rule proposal to the Commission that would govern the conduct of member broker-dealers operating on the premises of financial institutions. The NASD revised its rule proposal to address a number of issues raised by the commentators. NASAA announced at the Conference that it intends to propose a model rule for the states to consider that would be similar to the NASDís bank securities activities rule. The participants briefly discussed the issues raised by the NASDís proposed rule and the utility of NASAAís model rule under consideration.

3. Central Registration Depository ("CRD") Modernization

The CRD is a computer system operated by the NASD that is used by the Commission, the states, and the self-regulatory organizations ("SROs") primarily as a means to facilitate registration and licensing of broker-dealers and their associated persons. The NASD is in the process of implementing a comprehensive plan to modernize the CRD and to expand its use by federal and state securities authorities as a tool for broker-dealer regulation. As a result of the NASD's efforts, the modernized CRD system ultimately is expected to provide the Commission, the SROs, and state securities authorities with (a) streamlined capture and display of data, (b) better access to registration and disciplinary information through the use of standardized and specialized computer searches, and (c) electronic filing of uniform registration and licensing forms, including Forms U-4, U-5, BD, and BDW.

In the past year, the NASD decided that the Internet should become an integral component of the CRD modernization effort. Accordingly, the NASD submitted, and the Commission approved, a rule proposal that expands the NASD public disclosure program by amending the Interpretation of NASD Rule 8310 to include electronic inquiries as well as written and telephone inquiries.

Earlier this year, the NASD and the Commission issued releases adopting interim Forms U-4, U-5, and BD that incorporated previously-adopted language into a format compatible with current CRD technology. The interim forms became effective on March 16, 1998. The NASD expanded their public disclosure program to reflect the additional disclosure requirements of the interim forms.

The participants discussed the progress of the CRD modernization process and the interim Forms U-4, U-5, and BD, and prospects for increased Internet access to the CRD.

4. Penny Stocks/Micro-cap Fraud

Over the past year, the Commission has been actively pursuing a four-pronged strategy of investor education, focused broker-dealer inspections, increased enforcement, and regulatory initiatives in order to address the problem of fraud in the micro-cap securities market.

One of the Commissionís regulatory initiatives involves Rule 15c2-11 under the Exchange Act, which requires a broker-dealer to review current information about an issuer before it publishes a quotation for the issuerís securities in the non-Nasdaq over-the-counter markets. Because of the Ruleís "piggyback" provision, generally only the first broker-dealer has to review this information. Once the security is quoted regularly for 30 days, other broker-dealers can "piggy-back" off those quotes without reviewing any information about the issuer. On February 17, 1998, the Commission published a release proposing amendments to Rule 15c2-11 that would make several revisions to the Rule.

The NASD and the NYSE have also proposed several rule amendments that seek to address micro-cap fraud, including a rule requiring registration of persons who cold call customers, a rule requiring member firms to tape record certain conversations between registered representatives and their customers, a rule requiring disclosure of the risks involved in purchasing securities listed in the OTC Bulletin Board or in the pink sheets, a recommendations rule, and a rule requiring increased disclosure for clearing firms that clear securities trades for introducing firms.

The participants discussed the responses to the amendments to Rule 15c2-11 and the NASD and NYSE proposals, and whether other measures are needed to help combat micro-cap fraud.

5. NASD Proposals

The NASD has undertaken several regulatory initiatives in the past year, some of which were mentioned in the previous section. Three NASD initiatives have been filed with the Commission, and are currently under review. One of these rule proposals would require a member firm to tape record conversations between its customers and registered representatives if it hired a significant percentage of individuals from "Disciplined Firms." "Disciplined Firms" are defined as firms that have been expelled by a SRO or that have had their registrations revoked by the 12

Another proposed rule amendment would require clearing firms to (a) forward customer complaints about an introducing firm to the introducing firmís designated examining authority, (b) notify complaining customers that they have the right to transfer their accounts to another broker-dealer, (c) provide introducing firms with a list of exception reports to help them supervise their activities, and (d) assume liability for any mistakes or fraud made by an introducing firm that issues checks drawn on the clearing firmís account.13

Finally, a third proposed rule currently under review is Rule 1150, which would provide NASD members with qualified immunity in arbitration proceedings for statements made in good faith in certain disclosures filed with the NASD on Forms U-4 and U-5. The proposal, as described in an NASD Notice to Members, would require firms to give a terminated employee an opportunity to review the proposed Form U-5 language at least 10 days before it was filed with the NASD; any amendments would also be given to the employee before being filed.14

The NASD also is considering other initiatives, including the following three proposals. One proposed interpretive rule would require all unregistered employees of an NASD member firm who cold call prospective customers, either to solicit the purchase of securities or to market the member firmís services generally, to register as representatives.15 Another proposed rule amendment under consideration would limit the securities that a member can quote on the OTC Bulletin Board to the securities of issuers that are registered under Section 12 of the Exchange Act, certain insurance companies, and registered closed-end investment companies, but only if they are current in their reporting obligations.16 Finally, a third rule proposal would require a member to review current financial statements of an issuer prior to recommending a transaction in the issuerís OTC securities to a customer, and to deliver a disclosure statement to its customer prior to making an initial purchase of an OTC security for the customer and annually thereafter. 17

The participants discussed the above proposals, their implications for small businesses and NASAA members, and the comments received to date on those proposals that have been filed with the Commission.

D. Enforcement

The Enforcement working group had an agenda of nine items. The Enforcement group was joined by the Market Regulation working group to discuss two additional items. The session was attended by 59 enforcement officials, including representatives from 26 states and the District of Columbia, the SEC Division of Enforcement and each of the eleven SEC Regional/District Offices. Also attending were enforcement representatives from the NASD, the NYSE, the Amex, the U.S. Department of Justice ("DOJ"), and the Federal Trade Commission ("FTC").

As introductory remarks, the co-moderators of the Enforcement working group noted that the enforcement session has evolved in 15 years from the smallest of the four discussion groups to the largest.

A common theme of this year's agenda is the concern over the substantial presence of fraudulent trading in the securities of so-called micro-cap companies. The proliferation of off-shore offerings and the globalization of the securities markets were also noted. The need for effective enforcement of the regulatory provisions of NSMIA was stressed. Lastly, it was pointed out that the SECís Chairman has made investor education one of his priorities.

1. SEC Trends and Priorities

In his first day in office, the new Director of the SECís Division of Enforcement (previously, he was the SECís General Counsel) briefly described the recent enormous growth of the securities markets. The United States has become a nation of investors. One in three households owns stock. About $4.5 trillion is invested in mutual funds, in contrast to $2.7 in bank deposits. Investment company registrations increased 20% last year.

With respect to major enforcement trends and priorities of the SEC, 20% of the SEC case load involved fraudulent securities offerings, 19% concerned fraudulent financial disclosure by reporting companies and 10% involved illegal insider trading.

Fraudulent trading activities in micro-cap stocks is a major priority. The SEC has adopted a four-prong approach to curb micro-cap fraud. The first prong is early detection of problem trading through a vigorous inspection program. The second (and perhaps most important) is increased criminal enforcement. In this regard, the SEC Chairman has urged the expansion of ties with criminal authorities. Also, the SEC intends to quicken its enforcement response by seeking Temporary Restraining Orders and by instituting trading suspensions. For example, in the past four months, 11 trading suspensions were instituted, as compared to 12 in all of 1997. The third prong of the program is investor education. The last relates to proposed regulatory revisions designed to curb fraudulent offerings and trading (e.g., amendments to Rule 504, Form S-8, and Rule 15c2-11).

Another enforcement priority is broker-dealer supervision of sales activities, particularly with respect to satellite branch offices. The SEC, NASD-Regulation ("NASDR"), and the Comptroller of the Currency just announced settled administrative proceedings against NationsBank and its broker-dealer subsidiary, NationsSecurities.18 The respective enforcement actions were based upon charges of fraudulent sales practices and inadequate supervision of securities sales on the premises of bank branch offices. Included in the charges were misleading statements by sales personnel concerning, among other matters, whether the securities were federally insured. Also, there was a "blurring" of distinctions between investment and bank products, and with respect to the status of registered representatives. Securities officials from Texas and Florida assisted in the case.

In the municipal securities area, priority enforcement matters include the yield-burning cases resulting from excessive mark-ups in connection with arbitrage offerings, and violations of Rule G-37 of the Municipal Securities Rulemaking Board with respect to bribes, kickbacks and contributions by underwriters to local government officials.

In closing, the SECís Enforcement director urged that the respective enforcement agencies coordinate and leverage their respective remedial powers, particularly in the criminal arena.

2. State Trends and Priorities

The Chair of NASAA's Enforcement Section (Securities Commissioner of Maryland) briefly described major trends and priorities of state securities law enforcement.

The states are concerned about the apparent prevalence of fraudulent trading of micro-cap securities. In December, after three days of hearings, New York's Bureau of Investor Protection and Securities issued a comprehensive report on micro-cap fraud. [Appendixed are the first three pages from the "Overview" of the 139-page report].19

The states have developed a data base (of 33,000 records) for enforcement users (234 subscribers from 46 states). An e-mail network has been established between 38 state enforcement offices ("List Serve") in order to facilitate communications.

Three enforcement training programs are sponsored by the states: (1) in January, in conjunction with a supervisors conference; (2) in June, with respect to investigative techniques; and (3) later in 1998, with respect to litigation matters. NASAA recently adopted a strategic plan which includes efforts to develop enforcement training videos.

3. Joint Projects/Cases of Mutual Interest

The Chair of NASAA's Enforcement Policy Committee (Enforcement Director, California Department of Corporations) briefly described projects of interest to the SEC and the states. It was noted that the states are adapting to the state-SEC bifurcation of exclusive jurisdiction over certain securities and over certain investment advisers pursuant to the provisions of NSMIA (effective July 8, 1997).20 The core enforcement responsibility of the states is to curtail fraud at the local level. As a result of the decrease in registration authority, at least in California (where registrations are down 30%), state securities personnel are being reallocated to enforcement positions. Also, more effort is being expended upon monitoring sales agents and reviewing sales activities in broker-dealer branch offices.

There is an on-going project of developing a prototype surveillance system to uncover illegal web sites on the Internet. Major concerns are the identification of responsible parties and the authentication of related documents.

It was noted that California has proposed restructuring its regulatory system whereby the Department of Corporations will merge with the Department of Financial Institutions to form the Department of Financial Services.

Wisconsin and Pennsylvania have recommended to the SEC that the so-called "bad-boy provision" of ULOE be extended to Rule 504 small offerings under the Securities Act.

The National White Collar Crime Center is increasingly employing electronic techniques to support state and local efforts to combat economic crime.

4. NASD Regulation Trends and Priorities

The Vice President for Enforcement of NASDR briefly described the major enforcement trends and priorities of the SRO. The number one priority is fraudulent micro-cap trading.

Last year, more than 1,000 cases were instituted and 428 registered representatives were barred. Recently, a criminal assistance unit was formed, which will assist in both federal and state prosecutions.

Concerning micro-cap trading, the NASDR board of directors is reviewing three regulatory proposals intended to more effectively control fraudulent trading practices. First, only companies that report to the SEC pursuant to the periodic reporting provisions of the Exchange Act would be permitted to have securities quoted on the OTC Bulletin Board. Second, broker-dealers would be required to review recent corporate filings before making any transaction recommendations to customers. Third, such firms would be required to provide a disclosure document to customers describing generic differences between NASDAQ-listed stocks and over-the-counter stocks. If an OTC Bulletin Board company is more than ten days delinquent in filing a periodic report with the SEC, it will be automatically dropped from the Bulletin Board.

On April 17, 1998, the SEC approved an audiotaping rule concerning firms whose sales staff is comprised of more than 20% from expelled firms.21 All customer phone calls of such firms will have to be recorded for two years, and the recordings will have to be retained for three years.

Another concern with respect to micro-cap companies involves initial public offerings. Many such companies engage in bridge financing with underwriters. Proceeds of the offerings are used to pay huge bridge-financing fees to underwriters.

Another focus is the sale of mutual funds. The abovementioned NationsBank case is the latest example of violative activity in this area. The case underscores the misleading circumstances of selling efforts by banks. Investors do not realize that mutual funds can be as risky as stocks.

The recently approved OATS system (Order Audit Trail System) is intended to assure the integrity of the documentation of a securities order in order to facilitate investigative efforts by regulators.22 The system is designed to provide an autopsy of a trade through electronic recording and reporting of quotation, order, and transaction data. Time-stamping clocks at all securities firms will be synchronized under the system.

5. NASDAQ Enforcement regarding NMS/Micro-Cap Listings

The Vice President of NASDAQ in charge of enforcement of listing requirements briefly described his unit, which was established last summer. The focus, to a significant extent, is upon micro-cap companies and assuring that they are able to meet and maintain listing requirements. The areas of concentration of the unit include financial disclosure, financial restatement problems, extravagant future-event announcements, and other potential indicators of fraudulent activity. In the instance of persistent patterns of noncompliance, the Listing Investigations unit will seek delisting.

6. Trends and Priorities of the New York Stock Exchange

The Senior Vice President in charge of enforcement at the NYSE briefly described the major enforcement trends and priorities of the exchange.

A top priority is management's responsibility for brokerage firm employee trading violations. In about 25% of the exchange's cases, charges, including inadequate supervision, are filed against firms and/or management officials. In some instances, as part of a settlement, the exchange has required firms to hire outside legal counsel to review compliance policies and procedures. In one case, the exchange required the appointment of an independent director who also was required to chair the firm's audit committee.

Another priority is the integrity of the transaction order-taking system. Often, order tickets are incomplete or inaccurate, e.g., no time stamps, no indication whether the trade is long or short, etc. The exchange is instituting books-and-records cases based solely upon incomplete order tickets.

Recently, a criminal case was brought against eight floor brokers for violating Section 11(a) of the Exchange Act in connection with personal trades while on the floor of the exchange. The exchange assisted in this case of first impression in the criminal arena.

7. American Stock Exchange Trends, Priorities and Micro-cap Matters

The Amex Senior Vice President for Listing briefly described the major trends and priorities of his SRO.

In an effort to be as proactive as possible, the Amex conducts regulatory reviews of all prospective companies, including micro-cap companies. This process includes contacting the SEC and where appropriate, state and SRO officials. The review includes an analysis of bridge and Regulation S financings.

In certain instances of micro-cap type problems, the Amex has halted trading, which has proven to be an effective measure. In addition, in one case, the Amex relied upon the listing agreement to demand on-site access to company records.

In connection with the continued listing eligibility of a company, the Amex will, among other things, review associated promoters and public relations firms.

8. Dept. of Justice and U.S. Attorney Securities Fraud Programs

The Deputy Chief of the Fraud Section of the DOJís Criminal Division briefly presented an update of the securities fraud enforcement activities of the DOJ and of the U.S. Attorney Offices.

Micro-cap fraud is a major priority in federal securities prosecutions. At one point in the past year, five U.S. Attorney offices announced criminal cases, one after another, arising from micro-cap abuses.

Two concerns this year are: (1) strengthening and streamlining procedures so as to effect quicker referrals to U.S. Attorney Offices; and (2) enhance coordination between the national securities/commodities task force and regional working groups (in Los Angeles, New York and Miami).

The Attorney General recently clarified the policy on parallel proceedings in a memorandum to U.S. Attorneys, noting a strong interest in permitting federal agencies to bring parallel cases, and establishing procedures to ensure effective coordination. It was also noted that the information technical working group of the states and DOJ is an extension of the National White Collar Crime Center.

9. Federal Trade Commission Internet Investment Ad Sweeps

A representative of the FTCís Bureau of Consumer Protection briefly described its enforcement efforts with respect to Internet matters.

A major objective is to get as many agencies as possible to participate in sweeps of fraudulent and misleading messages on the Internet. The FTC intends to intensify its Internet searches and to better coordinate with enforcement agencies concerning Internet-related problems. [Appendixed are pages 6-11 from a 31-page FTC report issued in April, concerning Internet fraud.]

In the past year, the FTC has launched seven surf-day initiatives involving a number of areas (none concerned investments). Thousands of websites were searched, employing developed protocols. Up to 70% of the websites that were contacted, withdrew or changed their messages.

Combined Enforcement and Market Regulation Working Groups Discussion

At this point, the Enforcement and Market Regulation working groups merged to discuss the following items of mutual interest:

1. SEC/State Regulation of Micro-cap Trading

a. SEC Regulation

An Associate Director of the SEC Ďs Division of Market Regulation described the pivotal role that market maker quotations have in the micro-cap trading segment of the marketplace. As a result, the SEC has proposed changes to the quotation-submission provisions of Rule 15c2-11 under the Exchange Act.23 One of the proposals would make the Rule applicable to all market makers. Another would require annual updates of the required information and documentation. The changes are intended to facilitate enforcement against fraudulent activities.

Also, there is a greater focus in the SEC inspection and enforcement programs upon reviewing compliance by market makers with the penny-stock recordkeeping requirements of Rules 15g-1 through 15g-9 under the Exchange Act.

A proposal is being considered to make publicly available a repository of disciplinary-related information on individuals with respect to issuer-related violations.

Another area being reviewed is whether to require clearing firms to forward investor complaints concerning client introducing firms. The issue is the subject of NYSE and NASD rule proposals.

b. State Regulation

The Chair of NASAA's Broker-Dealer Section [Commissioner of Securities for Missouri] stressed the importance of SEC-state coordination on micro-cap fraud issues. He noted that regulatory representatives of the SEC, the states, NASDR, NYSE, Amex, and the Chicago Board of Options Exchange are scheduled to meet in June in Miami to discuss measures with respect to policing fraudulent micro-cap trading. In February, 33 states participated in an inspection sweep of 15 firms that engaged in micro-cap trading. As a result, 97 enforcement actions were brought and the registrations of 54 persons were withdrawn, suspended or revoked.

A new potential problem involves day-traders in the OTC market, who have been referred to in the press as "SOES bandits" (Small Order Execution System of NASDAQ). Such traders seek to take advantage of small incremental quotation differences between market makers. The traders may be acting on behalf of unregistered pools of investor funds, e.g., limited liability companies. The traders are not registered.

2. NASDAQ Surveillance regarding Small-Cap and Bulletin Board

The Director of Market Regulation for NASDR briefly described recent surveillance activities of his organization. The securities of about 10,000 companies are subject to the surveillance system.

In June, NASDR will initiate "Net Watch" - a surveillance program of the Internet. Some of the misleading communications include so-called "spam" messages promising doubling of profits.

Appendices to Enforcement Working Group Report

SEC Administrative Release - Cease and Desist Proceeding Instituted Against NationsBank and NationsSecurities, May 4, 1998

Report on Micro-Cap Stock Fraud, New York State Attorney General Dennis C. Vacco, December 1997

Fighting Consumer Fraud: New Tools of the Trade, A Report from the Federal Trade Commission, April 1998

III. Exhibits

A. Commenters

Investment Company Institute (Tamara Cain Reed, Associate Counsel)

Investment Counsel Association of America, Inc. (David G. Tittsworth, Executive Director)

Society of Asset Allocators & Fund Timers, Inc. (Jerry C. Wagner, Director, Legislative Liaison)

B. NASAA and SEC Representatives

NASAA Corporate Office

Neal Sullivan, Executive Director

Karen O'Brien, General Counsel

Jeffery Himstreet, Associate Counsel

Dan Kahl, Associate Counsel

SEC Executive Office

Commissioner Laura Unger

Gregg Corso, Counsel to Chairman Levitt

Belinda Blaine, Counsel to Chairman Levitt

Lourdes Gonzalez, Counsel to Commissioner Unger

Corporation Finance Working Group


Deborah Bortner

Blake Campbell

Timothy Cox

Felipe Cruz

Ronald Jones

David Massey

Marilyn Scanlan

Syver Vinje

Franklin Widmann


Jennifer Bethel

Martin Dunn

Barbara Jacobs

Anita Klein

Anne Krauskopf

Brian Lane

Mary Jo Parrino

John Reynolds

Broc Romanek

David Sirignano

Richard Wulff

Investment Management Working Group


Merilyn Bowman

Richard Cortese

Franklin Terry Elder

Thomas Geyer

Jack Herstein

Jeffery Himstreet

David Jonson

Melanie Lubin

Robert Maclellan

Donald Reis

Patricia Struck

Syver Vinje


John Avery

Jennifer Choi

Carolyn Gilheany

Kathy Ireland

Arthur Laby

Robert Leonard

Robert Plaze

Lori Price

Lori Richards

Catherine Saadeh

David Smith

John Walsh

Market Regulation Working Group


Larry Coates

Julie Croll

Mac Dodson

Jack Herstein

Morion Lewis

Anthony Patey

Maria Piccirilli

Don Saxon

Edison Shea

Daphne Smith

Donne Smith


Beth Badawy

Belinda Blaine

Larry Bergmann

Robert Colby

Christopher Gilkerson

Irene Halpin

Carlene Kim

Howard Kramer

Robert Love

Mike Macchiaroli

Catherine McGuire

Janice Mitnick

Lori Richards

Cathy Sabo

Nancy Sanow

Ann Vlcek

Other Organizations

Robert Clemente, NYSE

Lori Santamorena, U.S. Dept. of Treasury

Enforcement Working Group


Debra Bollinger

Scott Borchert

David Brant

Michael Burton

Michael Byrne

Rhonda Davis

Philip Feigin

Craig Goettsch

Mark Griffin

Jim Harlan

Barbara Harmon-Schamberger

Dave Hunter

Andrew Kandel

Patrick Kelly

Ralph Lambiase

Deborah Lincoln

Jean Lorrain

Bill McDonald

Charles Moore

Alejandro Ramos

Leslie Scott

Bradley Skolnik

Robert Terry

Ryan Ushijima

Charles Walker

Douglas Wilburn

Diane Young-Spitzer


Bill Baker

James Clarkson

David Fredrickson

Paul Gerlach

Colleen Mahoney

Joan McKown

William McLucas

Chris Mixter

Enforcement Working Group, coníd

Thomas Newkirk

Al Rusch

Nancy Smith

Richard Walker

Gerri Walsh

SEC Regional/District Offices

James Adelman, Boston District Office

David Bayless, San Francisco District Office

Harold Degenhardt, Fort Worth District Office

Randall Fons, Southeast Regional Office

Sandra Harris, Pacific Regional Office

Kenneth Israel, Salt Lake City District Office

Mary Keefe, Midwest Regional Office

Carmen Lawrence, Northeast Regional Office

Ron Long, Philadelphia District Office

Dan Shea, Central Regional Office

Richard Wessel, Atlanta District Office

Self-Regulatory Organizations

Dave Doherty, NYSE

Mike Emen, AMEX

Cameron Funkhouser, NASDAQ

Barry Goldsmith, NASD - Regulation

Gary Sundick, NASDAQ

Other Organizations

John Arterberry, U.S. Dept. of Justice

Steve Gurwitz, Federal Trade Commission

1 The commenters are listed in Exhibit A. The comment letters are publicly available for inspection in File No. S7-11-98.
2 Conference participants are listed in Exhibit B.
3 The Commission may designate securities listed on other exchanges to be covered securities if it determines by rule that the listing standards of such exchanges are substantially similar to the listing standards of the NYSE, Amex or Nasdaq/NMS. The Commission has adopted Rule 146(b) under the Securities Act which designates securities listed on the Chicago Board Options Exchange, Tier I of the Pacific Exchange and Tier I of the Philadelphia Stock Exchange as covered securities for purposes of Section 18.
4 Securities Act Release No. 7393 (Feb. 20, 1997) [62 FR 9276].
5 Securities Act Release No. 7511 (Feb. 27, 1998) [63 FR 10785]. An offering which does not meet the requirements of Rule 506 nevertheless
6 An offering which does not meet the requirements of Rule 506 nevertheless may qualify as a Section 4(2) non-public offering based on the facts and circumstances of the offering
7 Following the meeting, the SEC proposed restricting all Rule 504 securities. See Securities Act Release No. 33-7541 (May 21, 1998) [63 FR 29168].
8 Securities Act Release No. 33-7506 (Feb. 17, 1998) [63 FR 9648].
9 The SEC recently issued a release providing additional guidance. See Securities Act Release No. 7558 (July 29, 1998) [63 FR 41394].
10 As of August 7, 1998, the SEC had canceled the registrations of 4,202 investment advisers.
11 Securities Exchange Act Release No. 37850 (October 22, 1996) [61 FR 55593].
12 Securities Exchange Act Release No. 39361 (November 26, 1997) [62 FR 64422].
13 Securities Exchange Act Release No. 39349 (November 21, 1997) [62 FR 63589].
14 NASD Notice to Members 97-77 (November 1997).
15 NASD Notice to Members 97-58 (September 1997).
16 NASD Notice to Members 98-14 (January 1998).
17 NASD Notice to Members 98-15 (January 1998).
18 SEC File No. 3-9596; Securities Act Release No. 7532 (May 4, 1998). Appendixed to this Report is a copy of the SEC news release.
19 As a result of the hearings and the report, on April 22, 1998, a bill was introduced in the New York legislature to amend the Martin Act, the state's Blue Sky law. The provisions of the bill ("Investor Protection Act of 1998") are designed to enhance the licensing, inspection, investigative and prosecutorial authority of New York's Bureau of Investor Protection.
20 See Section 18 of the Securities Act, Section 15(h) of the Exchange Act and Section 203A of the Advisers Act.
21 Exchange Act Release No. 39883 (April 17, 1998) [63 FR 20232].
22 NASD Rules 6950-6957; Special NASD Notice to Members 98-33, dated March 1998.
23 Exchange Act Release No. 39670 (February 17, 1998) [63 FR 9661].