TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING FRAUD IN THE "MICRO CAP" MARKET BEFORE THE PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE Chairman Collins and Members of the Subcommittee: I appreciate this opportunity to appear before the Permanent Subcommittee on Investigations on behalf of the Securities and Exchange Commission ("Commission"), to discuss fraud in the micro capital ("micro cap") and "penny stock" markets and the Commission's efforts to combat such fraud. Summary We are living in an era of tremendous expansion in our capital markets. Last year, the Dow broke 6,000, and then 7,000, and this year broke 8,000. Daily volume on the New York Stock Exchange and Nasdaq is also at an all-time high, and initial public offerings are running at a record pace -- as shown in 1996, $50 billion was raised for new businesses. It is not surprising then that public participation in our securities markets has grown to record levels. Mutual fund assets ($135 million in 1980) are now a record $3.7 trillion, surpassing the $2.6 trillion that Americans have on deposit at commercial banks. As recently as 1980, only one in 16 households invested in mutual funds; today that number is more than one in three, as we have evolved from a nation of savers into a nation of investors. With this vast expansion in our markets and in public participation in those markets, we would expect to see an increase in the incidence of fraud. We have particularly seen an increase in abuses in the market for micro cap securities, which provides opportunity for small businesses to raise capital, but also provides opportunity for fraudsters to prey on innocent investors. Despite the record-setting pace of our markets, the Commission's resources have remained relatively constant. We must, therefore, rely increasingly on innovative and efficient ways of minimizing fraud and of maximizing the deterrence achievable with the Commission's limited resources. The Commission's campaign against fraud in the micro cap market is an example of such innovation. The three parts of our strategy are prevention, enforcement and regulatory initiatives. Prevention Obviously, the Commission recognizes that preventing securities fraud is far more effective than seeking to punish wrong-doers after the fact. We prevent fraud through our programs involving broker- dealer inspections, market and Internet surveillance, and investor education. Enforcement The Commission's Division of Enforcement has been working in partnership with the criminal authorities to lock up recidivist brokers and deter wrongdoers. Indeed, in the past year alone, at least 80 individuals have been charged or prosecuted through the coordinated efforts of the Commission and the Department of Justice. The Commission has also ======END OF PAGE 2====== coordinated its activities with other securities regulators to maximize our resources and stop micro cap fraud at its earliest stages. Regulatory Initiatives Over the last several months, the Commission's staff has worked with the New York Stock Exchange, Inc. ( NYSE ) and the National Association of Securities Dealers, Inc. ( NASD ) to develop rules that address the vulnerabilities in this sector of the market, such as a rule that increases the responsibility of clearing firms for notifying regulators of problems with introducing firms. The Commission is also studying how best to increase the amount of public information available regarding companies that are quoted on the NASD's over-the counter ("OTC") Bulletin Board and in the National Quotation Bureau's "Pink Sheets." I. Introduction The terms "micro cap" stock and "penny stock" have been used to describe a particular segment of the securities market. As both terms suggest, these stocks are generally low-priced securities issued by small companies. A penny stock is generally a security that is priced at less than $5 per share and is not traded on Nasdaq or listed on a stock exchange.<(1)> "Micro cap" stock generally describes a somewhat <(1)> Under the federal securities laws, penny stock is defined generally as: an equity security that is not listed on Nasdaq or a national securities exchange and either (a) has a price per share that is less than $5 or (b) whose issuer has net tangible assets that are less than $2 million, if the issuer has been in continuous operation for at least three years; or that are less than $5 million, if the issuer has been in continuous operation for less than three years; or whose average revenues are less (continued...) ======END OF PAGE 3====== broader universe of stocks than "penny stocks" -- the stock of any company with comparatively low capitalization, regardless of its price or where it is traded.<(2)> Thus, the term "micro cap" often includes "penny stock" as defined by the Commission. Fraud in the "micro cap" stock market follows a fairly predictable pattern. We find two different, but often related problems: * The first problem is aggressive, and sometimes fraudulent, sales practices, such as unauthorized trading in a customer's account. <(1)>(...continued) than $6 million for the last three years. See Section 3(a)(51) of the Securities Exchange Act of 1934, 15 U.S.C.  78c(a)(51), and Rule 3a51-1, 17 C.F.R.  240.3a51-1, promulgated thereunder. When the Commission adopted the $5 threshold for penny stocks it cited three reasons: 1) the perceived difficulty of manipulating higher valued stocks; 2) the fact that $5/share was the threshold for the ULOR/SCOR -- a uniform, streamlined state registration form for companies raising less than $1 million under the Rule 504 exception under Regulation D; and 3) the perception that legitimate small businesses could still raise capital and the liquidity for their shares would not be impaired. Exchange Act Release No. 30608 ("Penny Stock Rule Release"), 57 Fed. Reg. 18,004 (Apr. 28, 1992). <(2)> The term "micro cap" is not a term defined under the federal securities laws. Lipper Analytical Services, a mutual fund rating organization, generally categorizes micro cap companies as companies with market capitalizations of less than $300 million. Lipper-Directors' Analytical Data, Investment Objective Key, 2d ed. 1997. In general, securities of micro cap companies are quoted on Nasdaq's OTC Bulletin Board, in the National Quotation Bureau's Pink Sheets and on the Nasdaq Small Cap Market. ======END OF PAGE 4====== * The second problem involves manipulation of micro cap stocks by brokers, issuers and promoters to benefit themselves while harming innocent investors. Micro cap stock fraud presents a difficult challenge: to control the fraud without damaging the market for securities issued by legitimate small businesses. In this effort, the Commission is guided by three principles: * First, we must try to prevent fraud before it happens through early intervention and investor education. * Second, we must vigorously enforce the securities laws against con men and criminals who take advantage of investors. * Finally, we must continue to encourage legitimate capital formation through flexible regulation, especially for small businesses. II. Background A. What is Micro Cap Stock Fraud? Before expanding upon the Commission's response to micro cap fraud, it may be useful to briefly consider the nature of the problem. Stock manipulators need stock. They usually get it in one of two ways. One way is to find a "shell" company that already has issued publicly trading securities. This shell company typically has little or no operating history; few assets; few, if any, employees; and slim prospects for financial success. The shell is sometimes merged with a privately-held ======END OF PAGE 5====== company. The other vehicle for these individuals to get stock is to take advantage of exemptions from the federal registration requirements. The securities involved are usually traded in portions of the OTC market where public information is limited and a small number of brokers control the market. The securities are usually sold through hype or high pressure tactics, often involving "boiler room" operations where a small army of sales personnel cold call potential investors using scripts to induce them to purchase the "house stocks" -- those stocks in which the firm makes a market or has a large inventory. The information conveyed to investors often is at best exaggerated and at worst completely fabricated. Increasingly, stocks also are being touted on the Internet by unregistered promoters who work to raise interest in the stock. Once they have lured investors, the unscrupulous brokers employ a variety of inappropriate practices, from "bait and switch" tactics, unauthorized trading, "no net sales" policies (where investors are discouraged or actually prevented from selling their stocks) to churning (excessive trading in their accounts in order to generate commissions for the broker). The firm often charges excessive, undisclosed markups<(3)> and issues arbitrary stock quotations. Even if investors complain to the brokerage firm, it rarely disciplines its registered representatives or reports the investor complaints. <(3)> Excessive mark-ups in boiler room operations typically occur when a broker-dealer acquires a supply of stock at low cost and resells it at a substantially higher price to retail customers. ======END OF PAGE 6====== The promoters of these companies, and often company insiders, typically hold large amounts of stock and make substantial profits when the stock price rises following intense promotional efforts. Once the price rises, the promoters, insiders and brokers sell, realizing their profits, and the promoters cease their promotional efforts. After the manipulation of the stock ceases, the stock price plummets and innocent investors not only incur large losses, but may also lose their initial investments entirely.<(4)> B. The Commission's Previous Response to Micro Cap Fraud The last major outbreak of micro cap stock fraud occurred during the bull market of the 1980s. The Commission formed a Penny Stock Task Force in 1988 to coordinate its response to the problem. In 1989, the Commission adopted Exchange Act Rule 15c2-6, which requires brokers to obtain relevant financial information about their customers, document their penny stock recommendations and obtain written agreements from the customer for the first three penny stock purchases.<(5)> The intent of the rule is to require and document customer suitability when penny stocks are recommended. Armed with this new rule, the Commission devoted substantial resources to policing "penny stock" fraud, bringing 86 penny stock <(4)> This type of manipulation frequently is referred to as a "pump and dump" scheme. <(5)> In 1993, the Commission redesignated Rule 15c2-6 as Rule 15g-9, joining it with the other Penny Stock Rules. Exchange Act Release No. 32576 (July 2, 1993), 58 Fed. Reg. 37,413 (July 12, 1993). ======END OF PAGE 7====== enforcement actions in 1990 alone that represented 28% of all enforcement actions brought that year.<(6)> In 1990, the Commission approved the NASD's pilot project to bring more accurate and current information to the OTC market,<(7)> where micro cap stocks generally trade. The vast majority of micro cap stocks are not listed on exchanges or traded on Nasdaq. Before 1990, the National Quotation Bureau's "Pink Sheets" were the primary source of information about the stocks for this large group of smaller companies. The Pink Sheets are daily lists of stocks, published by a private financial information vendor, advertising the brokerage firms that make markets in these stocks. They sometimes include indications of interest or non-firm bid and offer prices for small quantities of stock. The Pink Sheets are not widely distributed and often contain stale information. In order to provide more public information about these stocks, the NASD created the OTC Bulletin Board, a centralized, automated alternative to the Pink Sheets that can provide real-time price and volume information. The pilot project was made permanent in 1997.<(8)> The OTC Bulletin Board has strengthened the NASD's ability to monitor those quotes that are displayed. <(6)> 1990 Annual Report of the U.S. Securities and Exchange Commission, at 6 and 156. <(7)> Exchange Act Release No. 27975 (May 1, 1990), 55 Fed. Reg. 19,123 (May 8, 1990) [Corrected Order, Exchange Act Release No. 27975-A (May 30, 1990), 55 Fed. Reg. 23,161 (June 6, 1990)]. <(8)> Exchange Act Release No. 38456 (Mar. 31, 1997), 62 Fed. Reg. 16,635 (Apr. 7, 1997). ======END OF PAGE 8====== Congress also has previously worked to address micro cap fraud. In 1990, the Subcommittee on Telecommunications and Finance of the House Commerce Committee took up the issue of penny stock fraud,<(9)> and ultimately Congress enacted the Penny Stock Reform Act of 1990 ("Penny Stock Act") as part of the Securities Enforcement Remedies Act ("Remedies Act").<(10)> The Penny Stock Act expanded the Commission's authority over such previously unregulated persons as promoters who associate with broker-dealers to sell penny stocks, and it required the creation of a toll-free hotline investors could call to obtain the disciplinary history of brokers. The Act also placed significant restrictions on so-called "blank check" offerings and required broker-dealers to disclose more information to customers when selling penny stocks. Finally, the Act called for the creation of an automated quotation system for OTC stocks, which the NASD and Commission already had underway with the OTC Bulletin Board. After the enactment of the Penny Stock Act, the Commission adopted new rules to implement the statute.<(11)> Among the requirements are rules requiring brokers to give customers specific information before the sale about the market for penny stocks and the broker's compensation. After the sale, the broker must provide clients with monthly statements <(9)> Penny Stock Market Fraud: Hearings on H.R. 4497 Before the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce, 101st Cong. 27 (1990) (Statement of Richard C. Breeden, Chairman of the Commission). <(10)> Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931. <(11)> Penny Stock Rule Release, supra, at fn. 1. ======END OF PAGE 9====== reporting the market value of the client's penny stocks. The goal of these rules is to provide information to investors and provide prospective investors with an opportunity to consider whether to make a purchase without the pressure of boiler room tactics. In 1991, the Commission amended Exchange Act Rule 15c2-11. That rule requires a broker-dealer to review financial and other issuer information before publishing a quotation in the issuer's stock in a quotation media such as the OTC Bulletin Board or the Pink Sheets. The rule also requires brokers to have a reasonable basis for believing the information is accurate. Finally, the amended rule requires broker-dealers to obtain a copy of any trading suspension order in the issuer's stock for the previous twelve months.<(12)> In 1993, the Commission conducted an extensive examination sweep with the NASD and state regulators to determine whether firms were complying with the Penny Stock Rules. The sweep found widespread adherence to the Penny Stock Rules, along with generally diminished activity in stocks covered by the Penny Stock Rules.<(13)> C. How Micro Cap Fraud Has Changed <(12)> Exchange Act Release No. 29094 (Apr. 17, 1991), 56 Fed. Reg. 19,148 (Apr. 25, 1991). <(13)> Joint Regulatory Penny Stock Examination Sweep (June 1994). Only 14 of the 129 broker-dealer examinations disclosed violations serious enough to warrant consideration of enforcement or disciplinary action. ======END OF PAGE 10====== Although the Penny Stock Act and Rules and the creation of the OTC Bulletin Board have by and large curbed certain abuses in the market for securities priced under $5, we are now finding that promoters and broker- dealers have adjusted their schemes so that the securities fall outside these measures. The simplest way around the Penny Stock Rules, for example, is to offer or sell securities that do not meet the technical definition of "penny stocks". The Commission today sees more fraud in mostly lower-priced Nasdaq-listed securities and in securities valued at $5 or more. In addition, the Internet is being used as a new vehicle to perpetrate securities fraud, especially in the micro cap market (including touting in "chat rooms", bulletin boards and on e-mail). The Commission has already brought enforcement actions involving fraudulent securities offerings, stock manipulations,<(14)> and investment advisers fraud through Internet newsletters.<(15)> The fraudulent securities offerings often promise unreal returns and include everything from interests in an eel farm,<(16)> an ethanol plant,<(17)> gold and diamond mining <(14)> SEC v. Huttoe, Litigation Release No. 15237 (Jan. 31, 1997), 63 SEC Docket 2383 (Mar. 4, 1997). <(15)> SEC v. Chelekis, Litigation Release No. 15264 (Feb. 25, 1997), 63 SEC Docket 2900 (Mar. 25, 1997). <(16)> SEC v. Odulo, Litigation Release Nos. 14591 (Aug. 7, 1995), 59 SEC Docket 3105 (Sept. 5, 1995), and 14616 (Aug. 24, 1995), 60 SEC Docket 122 (Sept. 19, 1995). <(17)> SEC v. Spencer, Litigation Release Nos. 14856 (Mar. 29, 1996), 61 SEC Docket 1960 (Apr. 30, 1996), and 15042 (Sept. 12, 1996), 62 SEC Docket 2409 (Oct. 8, 1996). ======END OF PAGE 11====== enterprises<(18)> and a coconut chip enterprise,<(19)> to more sophisticated offerings of sham <(18)> SEC v. Wye Resources, Inc., Litigation Release No. 15073 (Sept. 26, 1996), 62 SEC Docket 2762 (Oct. 22, 1996). <(19)> SEC v. Frye, Litigation Release Nos. 14720 (Nov. 15, 1995), 60 SEC Docket 2123 (Dec. 12, 1995), 15139 (Oct. 29, 1996), 63 SEC Docket 422 (Nov. 26, 1996). ======END OF PAGE 12====== promissory notes<(20)> and bonds purportedly issued by a nonexistent offshore company.<(21)> The Internet can be used for scams because it provides anonymity, broad circulation and the appearance of legitimacy at low cost. Accordingly, the Commission has been developing an effective surveillance strategy for the Internet.<(22)> However, the Commission is committed to the legitimate use of the Internet by honest market participants. III. The Commission's Program to Prevent Fraud in the Micro Cap Markets The Commission's program to prevent fraud in the micro cap market involves: * early detection and intervention; and * investor education. A. Early Detection and Intervention The Commission's program of early detection and intervention includes: (1) regular examination of broker-dealers; (2) surveillance of the Internet and the markets; (3) imposition of trading suspensions; and (4) an <(20)> SEC v. Sellin, Litigation Release No. 15012 (Aug. 12, 1996), 62 SEC Docket 1749 (Sept. 10, 1996). <(21)> SEC v. Octagon Tech. Group, Inc., Litigation Release No. 14942 (June 11, 1996), 62 SEC Docket 377 (July 9, 1996). <(22)> See discussion at pp. 14-15. ======END OF PAGE 13====== increasing resort to emergency litigation to stop active and on-going frauds. The Commission's Office of Compliance Inspections and Examinations ("OCIE") examines broker-dealers and oversees the examinations which the Self Regulatory Organizations ("SROs") -- the national securities exchanges and the NASD -- conduct of their members. Over the past several years, OCIE has focused its review of broker-dealers on their sales and trading practices. About 20% of examinations lead to referrals to the Commission's Division of Enforcement. OCIE is currently working closely with the NASD to focus on micro cap fraud through intense examination of broker-dealers. The examination staff also periodically conducts "sweeps" to determine if particular violations are widespread and then it issues recommendations and reports. For instance, in 1994 the Commission staff with the NYSE and NASD conducted a review of the hiring, retention and supervisory practices of nine of the largest brokerage firms. Two years later, the Commission, together with the NASD, NYSE and the North American Securities Administrators Association, Inc. ("NASAA") conducted a joint sweep to review the sales practices of selected registered representatives employed by small and medium-sized firms as well as the hiring, retention and supervisory practices of the brokerage firms that employ them. The second sweep revealed that some firms employ registered representatives with a history of disciplinary actions and customer complaints, use only minimal hiring procedures, and have supervisors in ======END OF PAGE 14====== branch offices who fail to review customer transactions adequately to detect sales abuses. We also found that almost one-half of the branches that engage in cold calling violated federal cold-calling rules.<(23)> As a result of the sweep, the Commission, NYSE, NASD and NASAA prepared a public report making specific recommendations designed to correct these problems.<(24)> For example, the report recommends more stringent hiring procedures for registered representatives; heightened supervision of registered representatives with a history of customer complaints, disciplinary actions or arbitrations; and training and supervision of cold-calling techniques. These joint sweeps have resulted in greater coordination among the regulatory authorities. The Commission's compliance staff meets quarterly with the NASD and NYSE to discuss how to improve our combined examination procedures. In addition, the Commission's regional examination staff meet regularly with their state counterparts and local NASD offices to determine how to better craft regulatory solutions. To combat securities fraud on the Internet, the Commission's Division of Enforcement, with the assistance of other Commission staff, has <(23)> In 1991, Congress passed the Telephone Consumer Protection Act, Pub. L. No. 102-243, 105 Stat. 2394 (1991), codified at 47 U.S.C.  227. The Federal Communications Commission enacted rules which, among other things, restrict the hours unsolicited calls can be made and require telemarketing firms to have "do-not-call" lists. 47 C.F.R.  64.1200. <(24)> Joint Regulatory Sales Practice Sweep, A Review of the Sales Practice Activities of Selected Registered Representatives and the Hiring, Retention, and Supervisory Practices of the Brokerage Firms Employing Them (Mar. 1996). ======END OF PAGE 15====== assembled a group of professionals who devote more and more resources to Internet surveillance. These professionals use the latest browsing software to monitor the Internet, including such message areas as newsgroups and bulletin boards. The on-line Division of Enforcement Complaint Center also provides an easy means for investors to send complaints to the Commission staff. Currently, the Commission receives between 50 and 70 on-line investor complaints a day. Suspicious activities are investigated, with enforcement action initiated where appropriate. In addition, the Commission staff has helped states develop their own Internet surveillance programs and meets regularly with the states, both individually and as part of regional and national conferences, to coordinate our surveillance and investigations. The Commission recently implemented a pilot program in our Florida regional office to intervene as soon as a potential sham micro cap offering is identified, which has already resulted in six trading suspensions.<(25)> The staff reviews regulatory filings for irregularities, or "red flags", that suggest the company may not be legitimate. After determining that the public interest and protection of <(25)> In the Matter of Amquest International, Ltd., Exchange Act Release No. 38695 (May 30, 1997), 64 SEC Docket 1862 (July 1, 1997); In the Matter of Green Oasis Environmental, Inc., Exchange Act Release No. 38588 (May 9, 1997), 64 SEC Docket 1395 (June 10, 1997); In the Matter of Genesis International Financial Services, Inc., Exchange Act Release No. 38565 (May 1, 1997), 64 SEC Docket 1259 (May 27, 1997); In the Matter of Historic Hotel Holdings, Inc., Exchange Act Release No. 38492 (Apr. 10, 1997), 64 SEC Docket 761 (May 6, 1997); In the Matter of OmniGene Diagnostics, Inc., Exchange Act Release No. 37966 (Nov. 19, 1996), 63 SEC Docket 709 (Dec. 17, 1996); In the Matter of Home Link Corp., Inc., Exchange Act Release No. 37292 (June 10, 1996), 62 SEC Docket 288 (July 9, 1996). ======END OF PAGE 16====== investors require it, the Commission can suspend trading in the stock. Trading suspensions can be a very potent remedy because: * Investors are put on notice of a potential fraud, hopefully encouraging more informed decision-making; and * Promoters and brokers are hit where it hurts most: in the pocketbook. The financial reward of a micro cap scheme depends on selling all the stock at the height of the manipulation. A trading suspension often leaves the promoters holding worthless stock before they are able to dump it on unsuspecting investors. Although a trading suspension only halts trading for a ten-day period, the suspension triggers application of Exchange Act Rule 15c2-11, which requires a market maker to have current and accurate financial information about the issuer before trading resumes. In other words, it is difficult for a broker-dealer to lawfully resume trading. B. Investor Education The Commission continually works to educate investors about how to avoid and report securities fraud through its Office of Investor Education and Assistance (OIEA). A well-educated investor is one of the most important defenses against securities fraud. Through Investor Alerts, an Internet Web Site<(26)> and a toll-free information line,<(27)> OIEA provides investors with practical tips on how to spot securities <(26)> http://www.sec.gov <(27)> (800) SEC-0330 ======END OF PAGE 17====== fraud. Numerous pamphlets and brochures have been developed to warn investors about scams, stating in "plain English" what every investor should know about investing. All of our publications are available free of charge on the Commission's website as well as through our toll free number. To educate investors and listen to their concerns, the Commission has coordinated -- and will continue to hold -- Investors' Town Meetings throughout the country. The town meetings are typically well-attended (often over 1,000 investors attended each meeting) and feature a series of seminars for investors on a wide variety of topics. We have also leveraged the modest resources required for these meetings by asking the securities industry to participate (we believe that investor education is among its most important responsibilities) and by recording some of the meetings so that they might reach audiences in the millions through television broadcasts. The Commission receives over 44,000 letters and inquiries from investors annually. Some investors simply want information. Others have complaints. Where the OIEA can help, it attempts to resolve the disputes, although it cannot act as lawyer or judge. Through its efforts, investors recovered more than $1.2 million last year. Sometimes the complaints are referred to the other divisions and offices of the Commission. Last year, nearly one-fifth of all investigations undertaken by the Division of Enforcement and "for cause" broker-dealer examinations were initiated, at least in part, in response to investor complaints. The Office tracks trends in complaints in order to identify problem brokers and practices, so ======END OF PAGE 18====== that the Commission's limited resources can be targeted at the areas of greatest need. The most significant trend is the rapid increase in complaints about cold calling. In 1995, the Office received 265 complaints primarily alleging cold calling. In 1996, the number of cold calling complaints doubled, rising to 427. As of July 28th of this year, the Office had already received 231 such complaints. IV. The Commission's Enforcement Program to Combat Fraud in the Micro Cap Market The Commission's enforcement program works in conjunction with state regulators, the SROs and criminal authorities to make life as difficult as possible for the con men and criminals who prey on American investors. The Commission has brought significant enforcement actions against micro cap stock brokers, such as A.R. Baron & Co., and micro cap stock issuers, such as Comparator Systems. The following enforcement actions recently brought by the Commission help illustrate some of the trends I have discussed above. A. A.R. Baron & Co. In 1996, the Commission brought an emergency administrative action against a broker-dealer, A.R. Baron & Co., Inc., and two of its principals for fraudulent sales practices, including rampant unauthorized trading in ======END OF PAGE 19====== customer accounts.<(28)> The Commission alleged that Baron and these principals manipulated the market for the stocks of two companies. Customers lost nearly $17 million as a result of these practices before the enforcement staff was able to shut the firm down. The brokerage firm consented to the entry of an order revoking its registration, and the Manhattan District Attorney s office subsequently indicted several principals. The Commission has so far recovered approximately half a million dollars in connection with the Baron case, and actions are still pending. B. Global Financial Traders, Ltd. The Commission alleged that Global Financial Traders, Ltd., an investment newsletter publisher, and certain affiliated entities and individuals: (1) obtained a large undisclosed position in the stock of American Image Motor Company, an OTC Bulletin Board security; (2) carried out a concerted telemarketing campaign and made recommendations in one of its newsletters to promote the stock, making material misrepresentations concerning the market in the stock; (3) sold large amounts of the stock from their own accounts; and (4) maintained the market price through stock manipulation. Early this year, the Commission obtained a temporary <(28)> In the Matter of A.R. Baron & Co., Inc., Exchange Act Release No. 37240 (May 23, 1996), 61 SEC Docket 2869 (June 18, 1996), Exchange Act Release No. 37248 (May 29, 1996), 62 SEC Docket 11 (June 25, 1996). ======END OF PAGE 20====== restraining order, an asset freeze and a preliminary injunction against the firms and its principals.<(29)> C. Comparator Systems Corp. The ability to artificially inflate the price of a stock, in this instance using the Internet, was showcased in the dramatic rise and fall of the stock of Comparator Systems Corp. The Commission brought an action against Comparator and three of its officers and directors, alleging that the defendants sold tens of millions of shares of the company's stock while falsely representing that they owned certain fingerprint technology.<(30)> Moreover, the company's financial statements had been falsified, allowing Comparator to remain listed on the Nasdaq Small Cap Market and avoid classification as a penny stock. Due to touting on the Internet, the company's stock price rose from $0.06 to $1.88 over three days, setting Nasdaq trading volume records. Prior to filing its complaint against Comparator, the Commission issued a trading suspension.<(31)> Comparator's former auditor has agreed to the entry of an order to cease and desist from further violations of the securities laws and to a bar from <(29)> SEC v. Global Financial Traders, Ltd., Litigation Release Nos. 15291 (Mar. 14, 1997), 64 SEC Docket 402 (Apr. 15, 1997), and 15338 (Apr. 17, 1997), 64 SEC Docket 969 (May 13, 1997). <(30)> SEC v. Comparator Systems Corp., Litigation Release Nos. 14927 (May 31, 1996), 62 SEC Docket 236 (July 2, 1996), and 15056 (Sept. 19, 1996), 62 SEC Docket 2593 (Oct. 15, 1996). <(31)> Exchange Act Release No. 37209 (May 14, 1996), 61 SEC Docket 2759 (June 11, 1996). ======END OF PAGE 21====== appearing or practicing before the Commission. Actions against other participants are pending. D. Repeat Offenders Once a fraudulent broker-dealer firm is put out of the securities business, it is important to prevent the staff that perpetrated that fraud from migrating to other securities firms. The presence of repeat offenders in the industry (commonly referred to as "rogue brokers") has concerned the Commission for several years. The Commission and other regulators can impose severe sanctions, including bars and suspensions, against those persons identified as serious securities law violators. The Commission has worked to ensure that a permanent bar from the industry is truly permanent<(32)> and that barred brokers do not "slip" back into the system. In less egregious cases, we can limit the securities activities of offenders, or impose other sanctions such as fines or injunctions to deter further misconduct. The Commission and the Justice Department have worked together to address the problem of rogue brokers. In November 1995 and again in May 1997, the Commission and the Justice Department announced the filing of charges against rogue brokers throughout the country. The brokers allegedly had engaged in a wide range of fraudulent conduct, including forging investor checks, engaging in unauthorized transfers of client <(32)> Exchange Act Release No. 34720 (Sept. 26, 1994), 57 SEC Docket 1941. ======END OF PAGE 22====== funds, selling securities of nonexistent issuers and creating false or fictitious account statements.<(33)> Under the federal securities laws, much of the responsibility for identifying and monitoring problem registered representatives lies with each individual firm and its supervisory staff. In April of this year, the SROs admonished the securities industry of its responsibility to be particularly aggressive in policing problem registered representatives.<(34)> The SROs' message -- echoing that of the Commission -- is that firms must maintain strong hiring procedures that either exclude or carefully evaluate applicants having records containing disciplinary actions, customer complaints, or adverse arbitration decisions. It also reminds firms that they must supervise such registered representatives closely, at both the branch manager and firm levels. E. Criminal Prosecutions In addition to our work with the state regulators and the SROs, the Commission coordinates its efforts to combat fraud with criminal authorities. Coordination with criminal authorities has produced some of the Commission's most dramatic efforts in combating fraud in the micro cap <(33)> "Second Set of Charges in Broker Case," New York Times, May 23, 1997, p.2; Attorney General and SEC Chairman Announce Nationwide Prosecution of Unscrupulous Investment Brokers, Department of Justice Release (Nov. 30, 1995). <(34)> The Joint Regulatory Sales Practice Sweep; Heightened Supervisory Procedures. Joint NASDR/NYSE Memorandum to Members and Member Organizations (Apr. 15, 1997). ======END OF PAGE 23====== market. The Commission will continue working to enhance these efforts. For example, in October 1996, the U.S. Attorney for the Southern District of New York, the Commission and the NASD announced the results of a year- long joint undercover operation in which FBI agents posed as brokers in a small Manhattan brokerage firm who were willing to accept payoffs to sell OTC Bulletin Board and Nasdaq stocks to their customers.<(35)> The payments were generally made by and through promoters, working with officers of the companies whose stocks were being touted. Payoffs were as high as 40% of the value of the stock. The FBI arrested 45 people, including promoters, brokers and company officials. Twenty-eight of those people have already been charged in Commission administrative proceedings for allegedly making undisclosed payments to brokers to sell stock. In November 1996, the U.S. Attorney for the District of Nevada announced indictments against 30 individuals for their roles in an alleged scheme involving, variously, undisclosed payments to brokers for sales of the securities of three small issuers, money laundering, conspiracy and racketeering. To date, 20 guilty pleas have been entered, including eleven individuals named in the indictments. Three Commission staff attorneys were designated as Special Assistant U.S. Attorneys in this matter and have played leading roles in the criminal investigation and litigation. The NASD staff also has substantially assisted in the investigations. In a <(35)> Criminal and Public Administrative and Cease-and-Desist Proceedings Announced Against 45 in Connection with Kickback Schemes, Exchange Act Release No. 37807 (Oct. 10, 1996), 62 SEC Docket 3027 (Nov. 5, 1996). ======END OF PAGE 24====== related matter, the Commission has instituted four administrative proceedings against 17 respondents. Successful coordination between the Commission and criminal authorities also resulted in the termination of a massive and on-going manipulation of the stock of Systems of Excellence, Inc., a manufacturer and distributor of video teleconferencing equipment with offices in Virginia and Florida. On November 7, 1996, after an expedited investigation, the Commission filed a civil injunctive action in federal district court against the former CEO of Systems of Excellence, the publisher of a daily stock newsletter that touted Systems of Excellence and was disseminated over the Internet, and eleven other individuals and entities. That same day, the Court ordered temporary restraining orders against all of the defendants, asset freezes, and other emergency relief, which effectively ended the scheme. The Commission also provided evidence it obtained to the Department of Justice, which opened a criminal investigation that now has resulted in guilty pleas by the former CEO and the newsletter publisher, who are both incarcerated, and a former auditor of Systems of Excellence. V. Regulatory Initiatives A. Modifications to Rule 15c2-11 Governing Initiating and Resuming Quotations ======END OF PAGE 25====== As noted above, Rule 15c2-11 is intended to prevent the publication of stock quotations in the OTC Bulletin Board, the Pink Sheets and similar media that may be used in fraudulent schemes. Before publishing the initial quotation for a particular stock, or after a trading halt, brokers must review such information as the issuer's most recent balance sheet, profit and loss, and retained earnings statements; the nature of the issuer's business; the nature of the products or services offered; the nature and extent of the issuer's facilities; and any relationship between the broker-dealer and company insiders. As a result of the recent rise in micro cap fraud, the Commission's staff is studying how to amend the rule; these amendments might take the form of requiring market makers to review additional financial information about the issuer or obtain updated information more regularly. B. Modifications to the Penny Stock Rules The Commission staff is also considering whether to recommend amendments to the Penny Stock Rules, such as broadening the definition of "penny stock" to include securities with a price greater than $5 per share and prohibiting a broker-dealer from recommending any non-Nasdaq OTC equity security without reviewing current information about the issuer. C. Regulation of the Relationship Between Introducing and Clearing Brokers The federal securities laws permit brokers that are often minimally capitalized -- with as little as $5,000 -- to "clear" their trades through ======END OF PAGE 26====== a more substantially capitalized firm (a "clearing broker"). These small brokers (an "introducing broker" or "correspondent") generally handle the "retail" relations with the customer -- opening accounts, taking orders, and making recommendations -- while the clearing broker clears and settles the trade by exchanging money and securities, handles the back office paperwork (primarily, providing trade confirmations and monthly statements), and delivers securities. The clearing broker may also execute the trade for the introducing broker. Clearing firms perform a valuable function by financing customer trades and smaller market makers, centralizing recordkeeping and safekeeping customer funds. Moreover, they help maintain competition in the securities industry by lowering the cost for new, small brokerage firms to enter the market. Unfortunately, some of these small introducing firms end up cheating the investing public. I have personally expressed the Commission's concerns in this area to Richard Grasso, Chairman of the NYSE, and Frank Zarb, Chairman of the NASD, and have encouraged them to develop rules to address this issue. The NYSE Board has already approved a rule that would, among other things, require clearing firms to send copies of customer complaints about introducing firms to the introducing firm's regulator. The Commission will consider this proposal carefully. The Commission's own examination staff is also conducting a series of examinations to look at the procedures of clearing firms, particularly those that clear for broker-dealers that make markets in OTC Bulletin Board and Nasdaq Small Cap stocks. ======END OF PAGE 27====== D. Listing Standards Because of concerns regarding micro cap fraud, the Commission has recently approved stronger Nasdaq listing standards.<(36)> Nasdaq and the national exchanges have established listing and maintenance standards, setting forth financial and other criteria that a company must satisfy to include its securities in Nasdaq or list its securities on an exchange. Listing on Nasdaq or the exchanges raises the visibility of a company and provides greater liquidity for its shares. Listing comes with a cost: companies are subjected to greater regulation, such as periodic financial reporting and rules on corporate governance. Higher listing standards should be studied to determine whether they would make manipulation and other fraudulent schemes even more difficult, as companies without substantial assets or expectations of revenues would be prevented from obtaining a listing for their securities. Raising the standards will result, however, in the de-listing of some companies from Nasdaq, forcing their shares to trade in markets that require less information. The Commission carefully weighs the balance between the cost of providing the information necessary to deter fraud and the need for a marketplace where the stock of legitimate small companies can trade. <(36)> Exchange Act Release No. 38961 (Aug. 22, 1997), 62 Fed. Reg. 45,895 (Aug. 29, 1997). ======END OF PAGE 28====== E. Telemarketing Within the last three years, the Commission approved new SRO telemarketing rules that impose "hour-of-the-day" restrictions, disclosure requirements and "do not call" lists.<(37)> These rules have since been incorporated into the examination modules of the Commission and the SROs. The Municipal Securities Rulemaking Board ("MSRB") has also adopted telemarketing rules for the municipal securities market.<(38)> Other SRO measures currently under consideration include: * implementing new Internet technology to identify potential frauds; * taping sales calls at broker-dealers that have hired sales personnel from firms that were expelled from the securities business; and * increasing SRO examinations targeted at sales practice abuses. F. The Role of State Regulation The Commission supports the states' authority to license broker- dealers and their associated persons. State regulators are justly <(37)> See, e.g., NASD Rules 2211 and 3110; Exchange Act Release No. 38009 (Dec. 2, 1996), 61 Fed. Reg. 65,625 (Dec. 13, 1996). NYSE Rule 440A and NYSE Interpretation of Rule 472; Exchange Act Release No. 38638 (May 14, 1997), 62 Fed. Reg. 27,823 (May 21, 1997). <(38)> MSRB Rule, SR-96-6, filed with the Commission on July 30, 1996, and amended on Nov. 1, 1996. ======END OF PAGE 29====== concerned about who is doing business in their backyard. Furthermore, as the "local cop on the beat," a state regulator is well positioned to monitor and respond to the numerous, but relatively small, abuses that occur daily in their state. These are abuses that the SEC and SROs, with limited resources and staff in certain jurisdictions, may not be able to respond to as promptly. In the aggregate, state regulators recover substantial sums of money for small investors. To address the need of broker-dealers and issuers for a predictable, uniform regulatory system, the states have already taken substantial steps to unify their regulatory schemes. The states, through NASAA, have worked effectively with the SROs, industry associations, and the Commission to develop more uniform requirements and procedures for the registration of broker-dealers and the licensing of associated persons. For example, NASAA and the states helped develop standardized forms such as the U-4 for licensing associated persons. NASAA and the NASD created the Series 63 examination to provide associated persons with a single, uniform examination relating to state securities laws, reducing the burden that had resulted from multiple state law examination requirements. Further, NASAA and the NASD were instrumental in developing the Central Registration Depository ("CRD"), the computer system that processes licensing applications and holds disciplinary records. Certain technological limitations in the CRD system have been identified -- the system relies on 1981 technology which sometimes makes conducting searches and producing reports difficult -- and we are working with the NASD and ======END OF PAGE 30====== NASAA to improve the system and to make it more widely and readily available. NASAA and the NASD have also developed the Temporary Agent Transfer ("TAT") program, which allows registered representatives without disciplinary histories to transfer from one firm to another without an interruption in business. More recently, NASAA created the Task Force on the Future of Shared State and Federal Securities Regulation as well as the MultiState License Committee, which are both exploring additional ways in which to make state regulation more uniform. In the National Securities Markets Improvement Act of 1996 ("NSMIA"),<(39)> Congress made the financial responsibility, recordkeeping and reporting requirements imposed on broker-dealers uniform at both the federal and state levels.<(40)> Congress also directed the Commission to study the impact of disparate state licensing requirements on associated persons of registered broker-dealers and to identify methods for the states to make licensing requirements more uniform. The Commission is consulting with state securities regulators, SROs, broker-dealers, and other industry participants to determine how best to work together without duplication. Because the Commission is in the process of completing this study and will submit a report to Congress by October 11, 1997, it would be premature to report the final conclusions of the study at this time. I can say, however, that the study does not call for the federal preemption of state licensing powers. <(39)> Pub. L. No. 104-290, 110 Stat. 3416 (1996). <(40)> Exchange Act Release No. 34-37850 (Oct. 22, 1996), 61 Fed. Reg. 555,930 (Oct. 28, 1996). ======END OF PAGE 31====== VI. Conclusion The Commission is dedicated to fighting fraud in the micro cap market through early intervention and prevention of harm, coordinated and strong enforcement, and regulatory initiatives that balances the need to facilitate capital formation with the elimination of fraud. This fight requires a unified front of federal and state regulators, prosecutors, and investors to make the costs of perpetrating a fraud in the microcap markets much greater than the benefits. We are completely committed to achieving this result, and we are deeply grateful for the support of Congress. Before closing our discussion of fraud in the micro cap market, it is important to remember that legitimate small businesses are the lifeblood of the United States economy. The Commission is proud of its efforts to reduce the regulatory burdens imposed on small businesses over the last several years: * Companies can raise up to $1 million dollars a year in seed capital, without complying with the registration requirements of the federal securities laws. * Companies can raise up to $5 million dollars a year through exempt public sales of securities using an offering document that, though reviewed by the Commission staff, includes unaudited financial statements, which cost substantially less than audited statements. ======END OF PAGE 32====== * Companies can "test the waters" for offerings up to $5 million dollars, allowing the company to determine whether there is public interest in its securities before being required to prepare documents for the offering. * Non-public companies can issue securities without registration to compensate their employees. Together, these initiatives permit small businesses to raise adequate capital without the cost of full federal registration.<(41)> We do not plan to turn back these efforts, however, we are concerned about any abuse of these measures and the harm that may cause not only investors, but also those businesses the rules were designed to help.<(42)> The Commission will continue to work in earnest to help legitimate small businesses gain access to the public capital markets while aggressively rooting out fraud among those that are not legitimate. Thank you for this opportunity to address the Subcommittee. <(41)> The federal securities laws are based on full and fair disclosure. Thus, companies that wish to raise capital in the national securities markets generally must register their securities with the Commission and file annual audited financial statements. The cost of preparing and distributing this information may affect the ability of some legitimate small companies to raise capital in the public securities markets. <(42)> For example, while not a small business initiative, the Commission recently modified Regulation S -- which permits United States companies to raise capital overseas without registering the stock with the Commission -- to better monitor the extent to which the stock was re-entering United States public markets. Exchange Act Release No. 37801 (Oct. 10, 1996), 61 Fed. Reg. 54,506 (Oct. 18, 1996). The Commission is currently considering additional modifications to restrict such re-entry of Regulation S stock. Securities Act Release No. 7392 (Feb. 20, 1997), 62 Fed. Reg. 9,258 (Feb. 28, 1997). ======END OF PAGE 33======