(letterhead: Charles Schwab & Co.)
April 28, 1998
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549
Re: Proposed Amendments to Rule 15c2-11 (File No. S7-3-98)
Dear Mr. Katz:
Charles Schwab & Co., Inc. and its affiliate, Mayer & Schweitzer, Inc. (collectively "Schwab") submit this letter in response to proposed amendments to Rule 15c2-11. 1 Schwab is the fourth-largest broker-dealer in the United States in terms of customer assets, and is the largest in some important market segments, such as electronic brokerage. Mayer is a leading Nasdaq market maker, and (as most relevant to these proposals) makes markets in approximately 520 non-Nasdaq OTC securities.
Schwab commends the Commission for its efforts to address abusive practices in the market for micro-cap securities. This market provides capital for many small businesses that otherwise have limited access to capital. In many cases, the securities of such smaller companies can offer investors substantial growth opportunities. However, these securities can sometimes be susceptible to unscrupulous sales practices by a small but persistent group of dishonest individuals and firms employing high-pressure sales pitches and false or exaggerated claims to market their "house stocks." This activity harms every legitimate issuer and broker-dealer. Moreover, investors and potential investors who are the targets of this activity as a result may be discouraged from doing business with legitimate firms and from saving and investing for their retirement and other needs.
As a market maker in hundreds of non-Nasdaq OTC securities, as well as a broker executing customer orders in thousands of additional names, we share the Commissions interest in promoting investor confidence in this segment of the market and strongly encourage the Commission and other securities regulators to focus additional resources on bringing fraud cases and imposing strong sanctions for abusive practices. 2 As described below, however, we have serious concerns about the Commissions proposed regulatory response to micro-cap fraud and its likely impact on liquidity for these securities. This letter addresses our specific concerns and suggests several alternative approaches that we believe would be more effective in combating micro-cap fraud.
B. Proposed Amendments
Rule 15c2-11 currently prohibits a market maker from publishing quotations for a non-Nasdaq OTC security unless it has reviewed certain specified information about the issuer and has a reasonable basis for believing that the information is accurate and was obtained from a reliable source. 3 This requirement does not apply when the broker-dealer publishes quotations for a security that is already the subject of regular and frequent quotations, in which case the market maker is allowed to "piggyback" on the quotations of the original dealer quoting the security. The proposed amendments to Rule 15c2-11 would eliminate the piggyback exception, so that all market makers quoting a security would have to review current issuer information for accuracy and reliability before quoting that security. In addition, the amendments would require market makers to update and review such issuer information annually and would expand the information required about issuers that do not file periodic reports with the Commission.
1. The Role of Market Maker Quotations
In holding market makers responsible for assuring the accuracy and reliability of issuer information, the proposed amendments require market makers to act as gatekeepers to screen out illegitimate micro-cap issues. In our view, this role misconstrues the function market makers perform in the marketplace. It is important that the Commission distinguish between the roles of (1) a dealer making markets in securities, (2) a broker executing unsolicited customer orders, and (3) a broker recommending securities to a customer. The micro-cap fraud problem is caused by brokers who recommend securities to their customers. Under SRO rules and the antifraud provisions of the federal securities laws, a broker who recommends a security to a customer must have a reasonable basis for that recommendation, which naturally requires that the broker have sufficient information about the security (although even in this situation the suitability analysis typically focuses more on the brokers knowledge of the customers financial status and objectives). 4 To a market maker, however, fundamental information about the issuer is most relevant when first initiating quotations. Thereafter, the trading of the security is based primarily on market interest and the interplay of supply and demand; the market maker does not trade with a view to whether the security represents a good or bad investment. While a market maker must assess how new information about the issuer will affect supply and demand, a market maker typically does not have the skills, ordinarily associated with research analysts, to establish a fundamental baseline value for an issuer. 5
The Commissions release essentially equates market maker quotes with recommendations. However, the release fails to explain how the harm it identifies (fraud and manipulation) is related to publication of quotes by market makers who are not involved in the fraud. While the release states that market makers can give a security "a measure of credibility through their quotations," we are not aware of any evidence that investors or the marketplace generally view market maker quotations as a representation by the market maker about the value of an investment. 6 To the contrary, it is generally understood that market maker quotes reflect only the value the market ascribes to the security i.e., what someone is willing to pay for it rather than the market makers view of what the security may be worth based on analysis of the companys fundamentals. The existence of market maker quotes in a security is no more a recommendation or indication of credibility than a newspapers publication of a classified advertisement. This is not to say that unscrupulous brokers may not occasionally refer investors to market maker quotations as evidence of a securitys value. However, that is a problem related to improper broker sales practices, not market making. 7 Instead of focusing on market makers, the Commission should focus on those who disseminate false information about issuers and thereby distort the market interest that legitimate market makers quotes reflect.
We are particularly concerned that the proposed amendments would impose an obligation on market makers for which they are not suited. For reporting issuers, we believe market makers have comparatively far less ability to identify potential financial fraud or going concern issues than do the issuers independent auditors, who have unrestricted access to the issuers books and records. At a minimum, we believe reporting issuers should be excluded from the proposed amendments. With respect to non-reporting issuers, the proposals would impose unrealistic and inappropriate obligations on market makers to obtain information from issuers over whom they have no control. The most significant non-reporting issuers are prominent foreign companies, which provide regular, audited financial statements but do not reconcile them to U.S. accounting standards; once again, we do not believe market makers have any comparative advantage in identifying fraud at such issuers. At most, we believe the proposed amendments should apply only to companies that are not audited in any jurisdiction, and as discussed below, even for these companies, we are concerned that the loss of shareholder liquidity may outweigh the benefits of the proposed amendments.
We believe the primary impact of the proposed amendments will be an increase in expensive and burdensome private litigation against firms that make markets in the securities of an issuer that subsequently gets into trouble or fails. Plaintiffs will argue that the market maker should have recognized red flags concerning the issuer and should have ceased its market making activities in the security. As a result, market makers will become an attractive "deep pocket" in private securities litigation. Mayer and a variety of its associated persons (as well as many other firms and their associated persons) have already been named in one state court class action on a variation of this theory, although Mayer and its associated persons were dismissed because the firm had never conducted any transactions in the security at issue with residents of that state. 8 Encouraging litigation of this sort will be a significant disincentive to making markets and providing liquidity. However, because market makers are not well situated to detect fraud or manipulation, we believe there will be little if any corresponding increase in the detection or prevention of fraud.
From the Commissions perspective, market makers might appear convenient gatekeepers for ensuring that only legitimate companies are quoted on the Bulletin Board and Pink Sheets, but in our view, this is a regulatory function more appropriately served by SROs. Indeed, it would be considerably more efficient and cost effective for an SRO to monitor and assess the accuracy of issuer information than to require the numerous firms making markets in non-Nasdaq OTC securities to individually establish the necessary accounting expertise and compliance procedures for reviewing such information. Particularly for the OTC Bulletin Board, which Nasdaq itself operates, the NASD could much more easily and effectively perform this monitoring function than can individual market makers. Even the Commission, through its use of trading halts and the accompanying obligation under current Rule 15c2-11 to establish a reasonable basis before reinitiating quotations, is in a better position to perform this type of ongoing monitoring than are individual market makers.
2. Jeopardizing Liquidity for Micro-Cap Securities
As discussed above, the proposed amendments would impose substantial regulatory burdens and liabilities on market makers. In light of these additional costs, we believe market makers who now provide liquidity for small issues may well find it prohibitively expensive to stay current and make markets in non-Nasdaq OTC securities. Market makers may decline to provide priced quotations in those securities, or may entirely cease making markets in some of these stocks. In either case, execution quality could suffer as investors find it harder to compare prices. In addition, the increased costs would translate into wider spreads for investors.
Specifically, we note that at Mayer, we would have to retain the assistance of outside auditors to evaluate the accuracy and reliability of issuer financials. However, our preliminary assessment is that given the level of trading in these securities, such a review would not be cost effective; if adopted, the amendments would therefore lead us to cease publishing quotes 9 or making markets in nearly all of the roughly 520 securities we currently follow, to the detriment of customers seeking liquidity in these issues.
Given the infrequent trading activity in most micro-cap securities, market maker liquidity is critical to ensuring a fair and orderly market. Market maker quotes provide more transparent and efficient prices. To the extent that the proposed amendments encourage market makers to drop stocks or discourage priced quotations, liquidity for these issues will suffer. The integration of ECNs into public quotations and the display of limit orders may have reduced the need for market maker liquidity for some heavily traded Nasdaq stocks. However, in the non-Nasdaq OTC market, frequently there are no well-priced standing limit orders, and market makers still play a vital role as a temporary provider of liquidity while finding the natural other side to a transaction. The irony is that the Commissions proposal would make markets for these securities more susceptible to manipulation: in the absence of market maker liquidity and pricing transparency, it will be easier for unscrupulous firms to dominate and control the market for a micro-cap security. The loss of transparency would also undermine SRO surveillance efforts by making it harder for regulators to monitor for unusual market activity.
Finally, the proposed amendments threaten the interests of minority shareholders, who may be forced to rely on the issuer for a market for their shares. The non-Nasdaq OTC market currently provides liquidity for many closely held companies that do not view themselves as public and do not make their financials available to the Commission, market makers or the public. While neither Schwab nor Mayer makes markets in such securities, Schwab receives orders from customers for these issues, which are among the most difficult securities in which to obtain quality executions. In some cases, it appears that the motivation for issuers to refuse to make information available to a market maker may be to eliminate the public market for their security and "go private." If market makers were unable to continue trading such securities because of the issuers reluctance to provide the requisite information, minority shareholders may have no alternative but to sell their shares back to the issuer at the issuers price. 10
Overall, the proposed amendments represent a very real danger that thousands of micro-cap companies will be forced from the Bulletin Board and Pink Sheets, where participants are regulated by the Commission and NASD, into less transparent markets in cyberspace or overseas. As discussed above, most of these OTC listings represent legitimate small businesses who must rely on this market to raise growth capital. As the Commission is aware, these entrepreneurial companies are responsible for most economic growth and new jobs in the U.S. economy. While we support the Commissions efforts to address fraud in the micro-cap market, it would be unfortunate if these efforts, however well intentioned, were to jeopardize market liquidity for the shares of these companies, undermine their ability to raise capital, and hinder the ability of minority shareholders in these companies to trade their positions. In considering abusive practices in the micro-cap market, we urge the Commission to avoid damage to an important market for the securities of legitimate small companies, particularly since the NASD has recently made it more difficult for small companies to become listed on Nasdaq. 11
3. Unnecessary Burdens on Competition
We believe that the proposal would impose burdens on competition that are not necessary or appropriate in the public interest. 12 For large capitalization foreign issuers that do not file periodic reports with the SEC, the proposed rules will put U.S. market makers at a severe competitive disadvantage compared to foreign market makers and exchanges. The order flow from U.S. investors in foreign securities will not disappear; it will simply migrate to foreign markets that are less transparent to investors. Typically, these foreign issues are traded actively on primary markets overseas and are not susceptible to the types of fraud and manipulation the Commission seeks to address. For domestic non-reporting issuers, the proposed amendments would give issuers that do not file periodic reports with the SEC a dangerous and unprecedented level of control over market makers in their securities: an issuer could "punish" a particular market maker by refusing to provide annual updated information.
4. The Proposals Costs Outweigh its Benefits
We do not believe that the limited benefits of the proposed amendments outweigh the substantial liquidity risks and regulatory and competitive burdens they would impose:
As an initial matter, we think the proposed amendments are unlikely to make a significant contribution to the Commissions goal of combating micro-cap fraud. Market makers are already subject to an obligation not to knowingly participate in any fraudulent or manipulative activity. As noted above, market makers are less well situated than independent auditors to prevent or detect fraud. Further, retail brokers who recommend a security already must have a reasonable basis before doing so. If this duty on the part of brokers has not been effective in deterring fraud and manipulation, it is not apparent why extending the duty to market makers is any more likely to prevent such activity. 13
We believe that the proposed amendments would have an adverse impact on market efficiency, competition, and capital formation. 14 The amendments would entail substantial costs and risks for market makers, issuers and the investing public, including:
substantial compliance costs related to obtaining and updating issuer information for the hundreds of non-reporting companies in which firms make markets;
accounting and legal resources to review the accuracy of issuer information; 15
loss of liquidity where market makers cease making markets;
wider spreads attributable to increased costs and decreased liquidity; and
greater difficulty for investors to compare prices and monitor execution quality.
The Commissions release does not adequately account for these and other potential costs. For example, the Commissions estimates of the burdens associated with the proposals completely fails to consider the impact on liquidity when market makers cease publishing quotes for a security, whether because of the increased costs of doing so or because they are unable to obtain the necessary information. Nor does the release account at all for the impact on dealer spreads or execution quality, or for the cost of increased private litigation to which firms would be exposed for purported failures to identify red flags. Because these increased costs will impair market liquidity and efficiency, the proposed amendments conflict with Commission and congressional efforts to promote capital formation and reduce regulatory burdens on small issuers. 16 Given the limited opportunities for small issuers to raise growth capital, we urge the Commission to carefully consider the potential costs and benefits of its proposal.
5. Focusing on Abusive and Fraudulent Practices
With its emphasis on market maker quotes, the Commissions proposal fails to address the primary source of abuses in the micro-cap market fraudulent sales practices by unscrupulous firms and individuals. The modus operandi for these frauds is all too familiar: misrepresentations and omissions, aggressive high-pressure sales practices, unsuitable recommendations, churning, unauthorized trading, failure to respond to customer complaints, and refusal to execute customers orders to sell "house stocks." The effort to combat micro-cap fraud therefore should start with increased regulatory scrutiny of broker sales practices in connection with solicited transactions. A good example of this type of approach is the Commissions recent approval of the NASD taping rule for firms employing a high percentage of brokers expelled from the industry for sales practice violations. 17 Other alternatives the Commission could consider:
Extend the NASDs trading halt authority to include suspicion of manipulation or inaccurate issuer information for non-Nasdaq OTC securities.
Expand the Commissions use of trading halts for manipulative activity in a security or incomplete or out of date information about an issuer.
Expand the NASDs Order Audit Trail System ("OATS") to include transactions in non-Nasdaq OTC securities, thus enabling the NASD to identify firms that are soliciting transactions in securities with unusual volume or price volatility.
Expressly prohibit brokers from recommending transactions in micro-cap securities unless they have obtained and reviewed certain specified information about the issuer and have a reasonable basis for believing that the information is accurate and was obtained from a reliable source.
Increase the level of warnings a broker must provide before recommending a transaction in a speculative or low-priced security.
Limit the ability of corporate insiders to trade in the public marketplace when sufficient current information is not publicly available. 18 Indeed, this would be an effective mechanism to achieve the Commissions goal of increasing the availability of issuer information.
In any case, we believe no regulatory solution to abuses in the micro-cap market can be as effective as a vigorous enforcement response. We therefore strongly encourage the Commission and other regulators to devote increased resources to market surveillance and enforcement. Regulators must have the surveillance tools to respond rapidly to unusual trading activity and other indications of suspected fraud, and the enforcement resources to aggressively prosecute violations. We encourage the Commission and the SROs to expel and permanently bar from the securities industry the firms and individuals who engage in these manipulation schemes, including not only the masterminds of the schemes but also the line-level sales people who defraud customers. The Commission and the SROs should focus on rapid prosecution of these schemes, rather than waiting to bring cases many years later. Because civil sanctions may not always be effective against these types of firms and individuals, we encourage the Commission and the SROs to seek the assistance of criminal prosecutors in addressing this type of fraudulent activity. In our view, an enforcement response to micro-cap fraud will be more effective, better targeted and less likely to impose significant costs on innocent third parties than the regulatory response that the Commission has proposed.
While we commend the Commission for its efforts to combat abuses in the market for micro-cap securities, we are concerned that the proposals would impose substantial costs for legitimate investors and firms that are disproportionate to the Commissions objectives and poorly tailored to the harm it identifies. The small group of dishonest firms and individuals responsible for micro-cap fraud are violating existing rules; imposing regulatory standards on market makers with no relation to the issuer and no connection to the fraud will not prevent the abuses.
Because of the importance of liquidity in the market for micro-cap securities, we respectfully suggest that the Commission consider more tailored approaches to abusive practices in the micro-cap market. Ultimately, we believe no regulatory solution will be as effective as vigorous enforcement of existing provisions. In this regard, we believe increased regulatory scrutiny of sales practices under existing sales practice rules (particularly for firms that do a substantial proportion of their business in this market) will address most of the abuses while avoiding the substantial liquidity risks, compliance costs and increased liability associated with the current proposals.
Please do not hesitate to contact us if you would like to discuss these issues in further detail.
Schwab Capital Markets
& Trading Group
-- Exchange Act Release No. 39670 (February 17, 1998) ("Proposing Release").
-- We also share the Commissionís desire to root unscrupulous firms and individuals out of the securities industry. Indeed, we recently referred to the Commission a matter (in which individuals falsely represented themselves to be associated with Schwab) which led to a successful micro-cap enforcement action. SEC v. Millennium Software Solutions, Inc. , SEC Litig. Rel. No. 15583 (Dec. 8, 1997).
-- 17 CFR 240.15c2-11 (1997).
-- See, e.g ., NASD Rule 2310 ( ∂ 4261). The NASD, by issuing and then withdrawing its Notices to Members 96-32 and 96-60, has in our opinion created unnecessary confusion on the issue of what constitutes a recommendation giving rise to suitability obligations. In our view, a recommendation is personalized advice given to a specific client. Providing links to third-party information over the Internet or preparing generalized proprietary research do not constitute recommendations. See Securities Industry Association letter to North American Securities Administrators Association (June 4, 1997). No regulatory purpose would be served by imposing new requirements on brokers who do not recommend securities to their customers.
-- Indeed, at a time when companies can trade at stratospheric valuations despite never having earned a profit, it is more and more difficult to talk about fundamental value as distinguished from the value set in the market by the actual interplay of supply and demand. Even if it were meaningful to talk about a fundamental value, it is not clear to us what a market maker should do if in its estimation the market value has diverged from its view of the stockís fundamental value.
-- See Proposing Release, supra note 1, at Part II.A.2.
-- It is telling that none of the cases cited in the Commissionís release were related to the publication of quotes by legitimate market makers with no connection to the fraud. See Proposing Release, supra note 1, at nn. 4, 10, 25, 62.
-- Joe Szpakowski v. Allen & Co. of Florida, Inc., et al. , Cause No. 49C01-9709-CT-2161 (County of Marion, Ind.).
-- Mayer currently publishes quotes in nearly all of the securities in which we make markets.
-- See, e.g ., "SEC Initiative on Tiny Stocks Stirs Debate," Wall Street Journal, February 9, 1998, at C1.
-- See Exchange Act Release No. 38469 (April 2, 1997).
-- See 15 U.S.C. 78w(a) (1997).
-- Further, it is not clear to us that fraud and manipulation are so particularly endemic to the non-Nasdaq OTC market as to warrant special requirements for this market. Indeed, the Commission itself has acknowledged that it is seeing more fraud in securities listed on Nasdaq. See 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, U.S. Senate (September 22, 1997).
-- See 15 U.S.C. 78c(f).
-- The Commissionís attempt to estimate the costs associated with the amendments, Proposing Release, supra note 1, at Part IV.B. ("The Commission estimates that it would cost $35 per hour to comply with the requirements based on a blended compensation rate of $35 per hour for clerical and supervisory compliance staff."), reflects a basic misconception about the extent to which firms will need to rely on lawyers and accountants to review issuer financials and other corporate and operational information. Indeed, the Commission itself has acknowledged previously that review of issuer information for accuracy can require the assistance of lawyers and accountants. See Exchange Act Release No. 29094 at n. 33 (April 17, 1991). A more realistic estimate would be $200 or more per hour.
-- See Small Business Regulatory Enforcement and Fairness Act of 1996, Pub. L. No. 104-121, 110 Stat. 857 (1996) (codified in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C. 601). In view of its emphasis on market maker obligations, we believe the Commissionís release does not adequately consider the impact of these proposals on small companies and their ability to raise capital. In this regard, we suggest the Commission consult with the Office of Advocacy of the Small Business Administration as part of its effort to evaluate the potential costs involved.
-- Exchange Act Release No. 39883 (April 17, 1998) (File No. SR-NASD-97-69), 1998 SEC LEXIS 713. In addition, we note that the SROs have recently taken steps to increase the obligations of clearing brokers. See, e.g ., Exchange Act Release No. 39349 (November 21, 1997).
-- Cf . 17 CFR 230.144(c)(2).