April 27, 1998
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: File No. S7-3-98
Ladies and Gentlemen:
On February 17, 1998, the Securities and Exchange Commission ("Commission") issued Securities Exchange Act Release No. 39670 (the "Proposing Release"), 1 proposing amendments to rule 15c2-11 under the Securities Exchange Act of 1934 ("Exchange Act"). The amendments, intended to "address abuses involving microcap securities," 2 would significantly increase the information requirements on market-making broker-dealers that post quotations in over-the-counter ("OTC") securities not traded on the Nasdaq Stock Market ("Nasdaq").
Hill, Thompson, Magid & Co., Inc. ("Hill Thompson") is one of the largest market maker in non-Nasdaq OTC securities, with over 3,800 issues quoted. Consequently, Hill Thompson supports the Commissions goal of preventing the perpetration of fraud and assuring that the public can invest their capital in this market without fear of being deceived. This proposal, however, takes an approach to combating fraud that would inevitably prove ineffective, while legitimate market-making firms would be burdened by increased compliance costs and
potential liabilities, investor holdings would be devalued by the lack of a liquid market, and legitimate issuers would be burdened with a concomitant loss of liquidity and access to capital. An examination of this oft-misunderstood market and its participants reveals that free and fair competition, combined with a concerted effort to surveill for and prosecute fraudulent market practices, is the preferable approach.
Summary of Proposal
In an attempt to combat microcap fraud, 3 the Commission seeks to amend rule 15c2-11 to "preserve the general integrity of quotations in the OTC market and to foster greater information transparency in a marketplace where issuers often are relatively unknown and their securities are traded infrequently" 4 by increasing the informational requirements necessary for a market maker to post quotations for such securities. All broker-dealers, including electronic communication networks ("ECNs"), that publish or submit for publication a quotation in a "covered OTC security" 5 would be required to:
1. Review fundamental issuer information (which varies based on whether the issuer files reports with the Commission pursuant to the Exchange Act);
2. Have a reasonable basis for believing that the information is accurate, current and from reliable sources; and
3. Record the source of the information, the date of review and the person responsible for compliance.
Such information would have to be reviewed on an ongoing basis at least annually if the broker or ECN publishes priced quotations for the security. Broker-dealers and ECNs would be required to make the information compiled under the rule available upon request to any person expressing an interest in effecting a transaction in that security.
A broker-dealers obligations under rule 15c2-11 would be augmented by the elimination of the "piggyback" exception, which is currently available where a security has been the subject of bid and ask quotations in an inter-dealer quotation system (e.g., the OTC Bulletin Board) for at least 12 of the previous 30 calendar days, with no more than 4 business days in succession without such quotations. 6 Accordingly, a market maker would need to compile and update the information prescribed by the rule for each security in which it published priced quotations. For Hill Thompson, this would require compliance for over 3,500 securities.
Hill Thompson believes that a survey of the nature of the securities traded in the microcap market, the typical pattern of microcap fraud and the current operation of rule 15c2-11 is necessary to examine how the proposed amendments would operate in practice and how the integrity and efficiency of the microcap market would be affected.
A. Description of Microcap Issuers
In its dealings in the microcap market Hill Thompson has come to recognize essentially three types of microcap issuers, each with its own motivations for being traded in the
microcap market and differing kinds of relationships with their public shareholders.
1. Infrequently-Traded Issuers
The "infrequently-traded" issuers are legitimate and successful companies, typically family-owned or otherwise closely-held, that have a minority of public shareholders. That these companies have any public shareholders at all is often the residue of a public offering conducted many years prior, or due to the sale of stock by a disaffected family member. The lack of a significant shareholder base, combined with little outstanding public float, means that there is no consistent daily trading volume in the securities of these issuers.
Given that effective control of these companies is typically held in the hands of a relatively small number of family members or other insiders, infrequently-traded issuers have no incentive to and generally would rather not deal with the concerns of public shareholders. These companies are typically not reporting companies and do not publicly disseminate financial information. Moreover, many such issuers are inclined to keep their stock prices artificially low, so they can attempt to buy back outstanding shares held by public investors and re-consolidate complete ownership in the hands of insiders. 7 Accordingly, the existing microcap market is the only way for public investors to realize any value from their holdings.
3. Emerging Issuers
A large percentage of non-Nasdaq OTC issuers are legitimate nascent companies who view this market as the best means of accessing capital, serving their investors and
expanding the market visibility of their businesses. Some companies initially traded on Nasdaq, but were removed to the microcap markets after failing to comply with Nasdaq listing standards. Many such companies are reporting companies.
The existence of a liquid microcap market is key to the development of these issuers. Whether their securities trade there initially or after removal from Nasdaq, an efficient and vibrant microcap market ensures potential investors that their shares will be freely tradable regardless of an issuers size. The liquidity and price transparency provided by market makers in these issues lowers overall risk to investors, because without a market-maker presence, "prices and spreads sometimes can fluctuate wildly." 8 This consequently lowers the cost of raising investor capital. "Without this source of capital for smaller and riskier companies, many of them, no doubt, would never become viable businesses." 9
4. Rogue Issuers
While they are a small minority, there are microcap issuers intent on defrauding investors. Such issuers are often in league with rogue broker-dealers, who manufacture trading volume and inflate prices in "pump and dump" schemes having common characteristics:
- control of the stock by one broker or a small number of brokers;
- matched purchases and sales of the stock to drive the price up;
- unauthorized purchases to drive the price up or to "park" the stock;
- large excessive spreads between the bid and ask prices;
- false and misleading representations about the stock; and
- the ultimate dumping of the stock at an inflated price by the brokers, insiders and others involved in the scheme. 10
Such schemes often involve an initial public offering and many issuers are reporting issuers, though such reports may contain false and/or misleading statements. Such issuers have incentive to keep stock prices artificially high, so that profits may be realized upon the sale of the stock to unwitting investors.
B. Regulatory Approaches to Microcap Fraud
In crafting any regulatory proposal that attempts to combat microcap fraud, it should be recognized that this is a problem of market conduct, rather than market structure. While non-Nasdaq OTC issuers have a low market capitalization, that does not automatically increase the potential for fraud; "it is not their size that is dangerous but the dishonest way in which their stock is represented and sold." 11 Accordingly, any anti-fraud initiative, whether enforcement or regulation-based, should target the market participants that conduct this activity and thus are the root of the problem.
The Commissions suggestion that legitimate market makers can unknowingly abet fraud by posting quotations 12 in a microcap security is unsubstantiated. The Commission has offered no evidence to indicate that rogue issuers, broker-dealers and promoters point to the independent quotations of other market makers as a basis for a stocks value as part of their attempts to force securities on unsuspecting investors. To the contrary, the quotations and trading activity of legitimate broker-dealers provide investors with the only pricing information available independent of the rogue market participants. Legitimate firms serve as a "reality check" when a stocks price has reached unrealistic price levels, by selling short and lowering their ask quotations. Rather than abetting fraudulent schemes, legitimate quotation activity frustrates attempts to keep prices artificially high. The Commission should not believe that by restricting the quotation activity of legitimate broker-dealers that the ability of non-legitimate firms to mislead investors will be curtailed.
Moreover, the Commissions over-emphasis of quotation activity generally as a component of microcap fraud is misguided. Microcap fraud can be perpetrated in the absence of quotation activity. Indeed, it can thrive: look to the recent activity in the stock of International Heritage, Inc. ("IHIN"), a company the Commission alleges operates a $150 million "pyramid scheme." 13 On the day after the expiration of a Commission-imposed trading suspension, IHIN stock resumed trading in the non-Nasdaq OTC market without any market maker quotations. Despite the absence of quotations, trading volume in IHI reached over 100,000 shares per day in the first two days after trading, with the share price fluctuating between $5 and $30 per share. 14 Such seemingly illogical trading activity evidences that quotations do not induce investors to purchase speculative securities, but rather unscrupulous brokers and promoters do. Accordingly, the impact of regulation aimed strictly at the integrity of quotations is likely to be an ineffective weapon against fraud.
Furthermore, in devising a regulatory solution to reduce this form of securities fraud the Commission should be aware that recent increases of "pump and dump" schemes are not the sole province of the non-Nasdaq OTC market. The Commission has reported that it "sees more fraud in mostly lower-priced Nasdaq-listed securities" 15 in the wake of the Commissions adoption of penny stock reform, and state regulators have verified that "much of this activity has been afforded to broker-dealers specializing in the sale of Nasdaq small cap securities." 16 The most notorious cases of "microcap" fraud, such as Comparator Corporation 17 and Systems of Excellence, 18 involved Nasdaq securities. Anti-fraud regulation tied to a particular type of security or issuer merely causes rogue broker-dealers to change venue, running their schemes using securities not covered by the new regulation. Accordingly, any anti-fraud initiative that targets microcap securities would not be completely effective and unfairly harm small issuers, brokers that make markets in such issuers and people that make legitimate investments in them.
C. Rule 15c2-11 and Microcap Fraud
The current operation of rule 15c2-11 under the Exchange Act serves to make market information less available to market participants, and even works to facilitate fraud in some cases. The nature of the piggyback exception creates a regulatory loophole that diminishes quotation competition and can be used to facilitate market manipulation. The problem is a matter of jurisdiction; the Commission cannot compel small issuers to release the necessary information to any requesting broker-dealer. In a typical microcap fraud scheme, which often involves the cooperation of insiders of the subject issuer, it is practically impossible for legitimate firms to obtain the necessary information. Accordingly, firms are forced to wait 30 days to post quotations for the security in reliance on the piggyback exception.
This lack of competition gives rogue broker-dealers a window of opportunity for market manipulation and investor deception. As the only firm allowed to post quotations for 30 days, the rogue firm may quote the stock at artificially high levels, create the appearance of a rising value without legitimate market interest, and be the sole source of quotation information that investors can turn to when valuing the subject security. Rather than restricting a market makers ability to post quotations, rule 15c2-11 should be altered to facilitate quote competition among market-makers from the date of initial trading in the microcap market. This would provide the price transparency and informational efficiency necessary to frustrate attempts at market manipulation.
Effect of Proposed Amendments
Hill Thompson believes that, in light of the current operation of the non-Nasdaq OTC market as discussed above, the Commissions proposed revisions to rule 15c2-11 would negatively impact legitimate broker-dealers, issuers and investors alike, without any concomitant reduction in the ability of rogue market participants to defraud investors.
Requiring the compilation of a rule 15c2-11 file for every quoted issuers, with annual updates, 19 would impose significant compliance costs and potential liabilities on broker-dealers which would likely lead to a decrease in microcap market-making. Wholesale firms like Hill Thompson, which often are the only independent broker-dealer making a market in a non-Nasdaq OTC security, would face enormous compliance costs in gathering and maintaining the required information for over 3,500 securities. For such firms the Commissions estimation that the "average" compliance burden for a broker-dealer would be 316 hours 20 is unrealistic. For reporting companies, the required information would be easily accessible through EDGAR, but the process of reviewing the information and documenting such review would be time consuming. For non-reporting companies, obtaining the required information would be quite difficult. Accessing such information through non-electronic means for literally thousands of issuers would be painstakingly slow. This process would involve thousands of man-hours
and, combined with the overhead costs of storing the information, may be cost-prohibitive to wholesale market making in microcap securities. 21 This compliance burden is in addition to the investment the NASD would need to make to process the tens of thousands of copies of Form 211 that market makers would need to file to continue quoting microcap securities.
Moreover, non-reporting issuers, who cannot be compelled by Commission regulations to divulge information, could prevent quotations in their securities by refusing to provide market makers with the requisite financial information. While the rule as modified would allow broker-dealers to substitute a documentation of its efforts to obtain certain information if the issuer is non-responsive, this does not extend to financial information. This would place undue control over quotations in the hands on non-reporting issuers.
Even if such information is obtained, market makers would face the troubling aspect of significant liability if a fraud in effected in a microcap stock the market maker currently quotes, absent any participation by the firm in the fraud. In the Proposing Release the Commission states that "responsible broker-dealers would be deterred from publishing quotations if they were aware of basic information about the issuer that suggested a possible fraud." 22 The Commission left unanswered, however, what duty this imposes on market makers that may suspect a stock is being manipulated, based either on the rule 15c2-11 information or outside sources. The language in the Proposing Release appears to create an implicit fiduciary duty between market makers and the investing public at large. Such a requirement would
impose a quasi-regulatory obligation on market makers to verify the legitimacy of an issuers operations and justify the value of its securities to investors. The Commission itself does not do this when reviewing issuer offering materials.
Any examination of microcap issuers to ensure legitimacy should be performed by NASDR, whose charge is to oversee OTC markets. Otherwise, legitimate market makers would be subjected to potential liability on several fronts; from investors alleging a market maker should have known of fraudulent issuer conduct, and from issuers who contest market-maker refusals to post quotations in their securities. Such risk exposure would significantly reduce market-maker return on capital. As a result, firms may reduce the number of markets made or cease making markets in microcap stocks altogether.
Rogue broker-dealers could use revised rule 15c2-11 to their advantage, driving legitimate firms out of the marketplace for securities that are the subject of their schemes. Unlike legitimate market-making firms, rogue broker-dealers make markets in only a few select "house" microcap issuers at any given time, often working in concert with issuer officials. This would work to reduce the practical burden of revised rule 15c2-11 compliance. Moreover, rogue firms could instruct associated issuers to frustrate attempts by legitimate firms to comply with rule 15c2-11 regarding their securities by withholding the requisite information. Even if such information is made available, legitimate firms may shy away from quoting such stocks if fraud is suspected from other sources. In the end, rogue firms may benefit from the rule, incurring fewer costs as compared to wholesale market makers and having fewer firms making markets in the securities that are the subject of their schemes, giving them greater control over the trading market and facilitating manipulation.
While the impact the Commissions proposal has on investors would vary based on the type of microcap security they hold, negative consequences would be incurred by all investors. Shareholders of thinly-traded issuers may find that the market for their securities disappears altogether. Non-reporting issuers can frustrate any market maker seeking to post a
quotation in their securities. As a result, an investors holdings in such companies may be practically worthless, with the only place an investor can turn to sell its holdings is the issuer itself, perhaps at artificially depressed prices.
Shareholders of emerging issuers would find the quality of the market for their securities greatly diminished. Compliance burdens and potential liability would likely cause broker-dealers to cease making markets in many such securities. As a result, the market would lack liquidity and transparency and be more volatile, reducing the value of securities held.
Investors that are the targets of microcap fraud would have little independent pricing information upon which to judge the value of securities. With legitimate firms no longer posting quotations in such securities, the only pricing information investors can turn too would be provided by rogue broker-dealers. An inflated share price quoted to an investor would be hard to recognize as suspect because it would be the only ongoing trading and price activity available to analyze.
The impact of a revised rule 15c2-11 on infrequently-traded issuers would likely vary based on their intent. Issuers acting in good faith would comply with the rule, provide the necessary information to market makers and incur increased costs. Issuers not concerned with their public investors may actually benefit from the rule by not complying. By failing to provide information, issuers could effectively prevent market-maker quotations, thus artificially depressing share prices and facilitating repurchases from public shareholders who can find no other market for their securities.
Emerging issuers would face higher capital costs. Even if such issuers are able to bear the costs of supplying the necessary information, the broker-dealer compliance burdens would lead to a reduction of market-making activity in microcap stocks as a whole, impacting the attractiveness of such securities. The absence of a liquid market in securities outside of Nasdaq would increase the risk associated with investing in emerging companies. Increased risk would reduce investor interest and thus increase capital costs, forcing companies to turn to alternative forms of financing.
Rogue issuers would be virtually unaffected by the new requirements. Acting in concert with rogue broker-dealers, such issuers could continue to participate in schemes to defraud investors. The requisite information would be supplied to the rogue broker so the firm could act as market maker in the issuers securities. Requests for information from legitimate market makers may be ignored, because the lack of independent market-making interest in these securities could actually increase, rather than inhibit, an issuers ability to facilitate fraud and market manipulation.
While Hill Thompson does not believe the Commissions proposed modifications to rule 15c2-11 would achieve its anti-fraud objectives or improve the quality of the microcap market, we do not suggest that microcap fraud is not a serious problem that regulators should ignore. We suggest several potential regulatory solutions that might effectively deter microcap fraud by targeting the purveyors of fraud and limiting their capacity to mislead investors with relative impunity.
A. Trading Suspensions
Currently only the Commission has the power to suspend trading in non-Nasdaq securities. This deprives the NASD of a crucial tool necessary to protect investors when they suspect microcap manipulation. For example, in August 1997 over 12 million shares of the common stock of Discovery Zone changed hands in the microcap market over a three-day period, even though the stock had previously been declared worthless as part of a bankruptcy reorganization. While the NASD monitored the situation, they were powerless to halt the trading, and the lag time between NASD recognition of the problem and Commission action meant some investors were persuaded to buy worthless stock in the interim. 23
The NASD should be empowered to act when fraud is suspected. Often times the NASD suspends trading and eventually de-lists a security from Nasdaq, only to see trading volume for that security surge in the microcap market as rogue firms dump their inventories on unsuspecting investors. The Commission should work with the NASD to establish a framework where the NASD would be authorized to suspend member firms from facilitating trades in a non-Nasdaq stock temporarily, and then disclose its findings to the Commission so that a permanent resolution of the situation can be made.
B. Disclosure Requirements
Microcap fraud at its essence is the recommendation of unsuitable investments to unsophisticated investors. Accordingly, efforts targeting broker-dealers that recommend microcap stocks to their customers, rather than firms that simply facilitate an efficient market in these securities, are likely to be far more productive. The NASD has recently proposed requiring member firms to review issuer financial information prior to recommending a non-Nasdaq OTC equity security and provide customers with risk disclosure statements prior to effecting a transaction in such securities. Firms could also be required to make pre and post-trade disclosure (e.g., on customer confirmations and account statements) that a recommended issuer does not file current financial information with the Commission. This would require rogue firms to put investors on notice regarding the type of securities being recommended, making the task of soliciting purchase orders that much more difficult. An issuers status as a non-reporting company could also be included directly on the OTCBB or the pink sheets to put investors on notice that current financial information regarding an issuer may not be available.
C. A Central Information File
A central information database of the information currently required by rule 15c2-11 would be the most efficient means of increasing the amount of publicly available information regarding microcap stocks. The concept has been suggested by the NASD 24 in the past and would be more cost-effective than requiring each market maker to compile basic financial information. This would also be consistent with the congressional mandate under the Paperwork Reduction Act of 1995 25 to minimize compliance burdens associated with the collection of information. Such information could be maintained by the Commission or the NASD and made available to investors via the Internet, so a truly independent source of microcap issuer information was available. Investors would then not be reliant upon the broker-dealer that is recommending a microcap stock to supply them with accurate financial information.
D. Heightened Net Capital Requirements
The Commission should consider raising net-capital requirements for market-making firms in order to make the business of microcap fraud unprofitable for rogue broker-
dealers. Currently market makers need only maintain net capital of $2,500 for each security in which it makes a market priced over $5 per share, and $1,000 for each security priced less than $5. 26 Given that rogue firms typically make markets in the relatively few stocks that are the subject of their schemes, only a minimal capital investment in necessary to get into the business of microcap fraud and its multi-million dollar potential.
A higher minimum net capital threshold (e.g., $2,500 per security but no less than $2,000,000) would require broker-dealers to make a commitment to legitimate market-making and force rogue firms to provide a pool of capital from which defrauded investors could seek compensation. Larger net capital requirements would likely not result in decreased competition because effective efforts to combat microcap fraud would increase investor confidence in the market and bring increased trading volume.
E. Increased Enforcement
While the devotion of more resources to combat microcap fraud seems obvious, a vigorous enforcement program is an essential deterrent. Certain securities industry participants
always have, and unfortunately always will, shirk from responsible business activities in favor of stealing the hard-earned money of unwitting investors. The regulatory response to such conduct should be swift and the punishment severe. Imposing criminal penalties on the perpetrators of fraud, rather than cumbersome regulation for legitimate firms, would be the most effective means of reducing instances of market misconduct.
Hill Thompson supports the Commissions efforts to combat abuses in the nations microcap markets. Any regulatory effort that is not grounded in a practical analysis of the character of the microcap market and the mechanics of microcap fraud, however, will not adequately serve its noble purpose. While the Commission should not refrain from new regulation for the protection of investors, burdening legitimate market participants with difficult and costly compliance obligations as the price of participation in the microcap market would not only leave the capacity for fraud undiminished, but greater than ever as reduced competition leaves investors at the mercy of unscrupulous broker-dealers and non-responsive issuers. The Commissions approach should instead be targeted at the perpetrators of fraud and their schemes, while strengthening the levels of competition and efficiency in the microcap market.
-- 63 Fed. Reg. 9661 (February 25, 1998) (File No. S7-3-98).
-- Proposing Release at 4.
-- As used recently, the term "microcap fraud" applies not only to fraud in the context of non-Nasdaq OTC equities, but as regards to all securities having a relatively low market capitalization for which there is little widely-available independent financial information or research. Microcap fraud schemes often involve Nasdaq securities. See infra n.17-18 and accompanying text.
-- Proposing Release at 7.
-- By virtue of exceptions from rule 15c2-11, "covered OTC securities" would include all equity securities not traded on a national securities exchange or the Nadsaq Stock Market.
-- See rule 15c2-11(f)(3)(ii) under the Exchange Act.
-- See, e.g., Head of Kohler Family Unveils Plan To Buy Out Holders of Fixtures Firm , The Wall Street Journal, April 7, 1998, at B16. Family members owning a majority interest in Kohler Co., an OTCBB-traded plumbing-fixture concern with over $2 billion in annual sales, were offering to buy out non-family shareholders at $52,700 per share, which is less than half the price at which the stock has recently traded.
-- No Market Makers Makes Some Stocks Orphans of the Bulletin Board , Dow Jones News Service, (Available in Westlaw) April 20, 1998.
-- Testimony of Dennis Vacco, New York State Attorney General, before the New York State Attorney General Public Hearings on Micro-Cap Stock Fraud ("NYSAG Hearings"), July 29, 1997.
-- Id .
-- Testimony of Mark Griffin, President, North American Securities Administrators Association, before the NYSAG Hearings, supra note 7.
-- Proposing Release at 13.
-- See Commission Files Emergency Civil Action Against International Heritage, Inc. , SEC News Digest 98-51 (March 17, 1998).
-- See IHI Stock Riding Like a Bumblebee , The Raleigh News & Observer , March 31, 1998 at D1.
-- Testimony of Arthur Levitt, Chairman, Securities and Exchange Commission, before the Permanent Senate Subcommittee on Investigations, Committee on Governmental Affairs concerning Fraud in the "Micro Cap" Market, September 1997 ("Levitt Testimony").
-- Testimony of Daren O’Connor, Investigator, State of New Jersey Bureau of Securities, before the NYSAG Hearings, supra note 9.
-- See Levitt Testimony, supra note 15, at 21.
-- Id . at 25.
-- The fact that inter-dealer quotation medium such as the OTC Bulletin Board require priced quotations would require such updates, even with the rule’s exception for unpriced quotations. Query why the Commission would include such an incentive to post unpriced quotations, given the lack of transparency and potential for reduced execution quality they create?
-- Proposing Release at 67.
-- Given that wholesale firms are often the only brokers willing to make markets in many microcap securities, this could have a disproportionate impact on market quality.
-- Proposing Release at 13.
-- See Discovery Ticker Still Ticking , Ft. Lauderdale Sun-Sentinel , August 2, 1997 at 13C (with NASD officials noting they had "no authority to stop trading of the stock.").
-- See Exchange Act Release No. 27247 (September 14, 1989).
-- 44 U.S.C. 3501 et seq .
-- Rule 15c3-1(a)(4) under the Exchange Act.