Jonathan G. Katz, Secretary
RE: Proposed Amendments to Rule 10b-18
Dear Mr. Katz:
We are pleased to submit this letter to the Securities and Exchange Commission (the "SEC" or "Commission") on behalf of Stephens Inc. ("Stephens"), a registered broker/dealer, in response to the Commission's request for comments on its proposed amendments to Rule 10b-18, which provides issuers with a "safe harbor" from liability for manipulation when they repurchase their common stock in the market in compliance with the rule's provisions, as contained in Release No. 33-8160 (December 10, 2002) (the "Proposing Release").1
Stephens is a registered broker/dealer with substantial experience working with issuers in connection with their Rule 10b-18 repurchase programs and with institutional investors. In particular, Stephens' focus is on medium and small issuers. In this respect, Stephens has significant knowledge of the role of block trades in the markets for securities of such medium and small issuers.
Stephens appreciates that there are a number of provisions of Rule 10b-18 that should be clarified and updated, particularly in light of the changes in structure of the securities markets since the Rule's adoption in 1982 and the subsequent adoption of Rule 10b5-1. The purpose of this letter, however, is to recommend that the Commission retain the exception for block purchases.
Retain the Block Purchase Exception
The Commission proposes to eliminate the block purchase exception from the calculation of average daily trading volume ("ADTV") and, thereby, also include block purchases within the current 25% and the proposed 100% volume limitations (the "volume limitations"). While Stephens commends the Commission's efforts to bring simplicity to the calculation of ADTV, it disagrees with the Commission's overall conclusion that block purchases should not be treated differently than less-than-block trades under Rule 10b-18. Stephens urges the Commission to not view the block purchase exception as undermining the purpose of the volume limitations of the rule.2 The proposal to eliminate the ability of issuers to make block purchases outside of the volume limitations of Rule 10b-18 fails to take into account that the block purchase exception not only serves a vital purpose for medium and small issuers but also has been beneficial to the effectiveness of Rule 10b-18 for all issuers and facilitated issuer and broker/dealer compliance therewith.
Stephens recommends, therefore, that the Commission adopt the Commission's proposed definition of "ADTV" in Rule 10b-18(a)(1) that would include block purchases in the calculation, but amend Rule 10b-18(b)(4) to exclude such block purchases from the volume limitations. Not only does this recommendation embrace the simplicity inherent in the Commission's proposed change to the manner in which ADTV is calculated, it also recognizes that, as elaborated below, there are critically important reasons to retain the block purchase exception - foremost among them, a recognition of the hardship that will be worked on small and medium issuers, and their shareholders, if the block purchase exception is eliminated.
Stephens acknowledges that including block purchases in ADTV but excluding them from the volume limitations will, for companies that engage in block purchases, increase the number of shares that can be repurchased within the Rule 10b-18 safe harbor. Stephens' does not believe that this is an undesirable result, as more fully set forth below with respect to the adequacy of the 25% and proposed 100% volume limitations. If the Commission is uncomfortable with this result, however, Stephens observes that one way to mitigate the increase in the volume limitations and decrease reliance on the block exception would be to raise the threshold for the number of shares constituting a block. Rule 10b-18 currently defines a "block" as the purchase of a quantity of stock with a purchase price of at least $200,000 or of at least 5,000 shares that have a purchase price of at least $50,000. The Commission asked in the Proposing Release whether the 5,000 share limitation should be increased to match the standards of the New York Stock Exchange ("NYSE") and The Nasdaq Stock Market, Inc. ("Nasdaq"), which define a "block" as the purchase of a quantity of stock that has a purchase price of $500,000 or more or at least 10,000 shares of stock with a purchase price of at least $200,000. Stephens agrees that the "block" definition should be revised to conform to the definition relied upon by the NYSE and Nasdaq. Using the NYSE/Nasdaq block definition would subject smaller block transactions (i.e., those that currently satisfy the Rule 10b-18 test but would not meet the NYSE/Nasdaq test) to the 25% volume limitation.
Block Transactions Have a Low Potential for Manipulation
In the Proposing Release, the Commission expresses concern that "the block exception may allow issuers to dominate the market for their securities in a way not originally contemplated by the safe harbor,"3 but provides neither any empirical support for this concern nor any findings of manipulation by issuers using the block purchase exception. Stephens disagrees with the SEC's view that there is a potential for market domination through the block trade exception. Stephens believes that the SEC was correct in stating at the time the block exception was adopted, and believes that it continues to be true, that "the market impact of a block purchase is likely to be less than that of a series of purchases of smaller amount that in the aggregate are equal in size to the block but are accomplished over a period of time."4
Stephens' experience is that block trades are generally accomplished in negotiated transactions and are typically priced at a discount to the market, diminishing the opportunity for manipulation. Moreover, securities markets apply special trading rules to block traders that regulate the execution of such trades, making manipulation less likely.5 Rule 10b-18 itself also contains safeguards against manipulation with respect to issuer block repurchases. A broker/dealer acting for an issuer with respect to Rule 10b-18 purchases cannot accumulate a number of small purchase transactions for the purpose of selling them as a block to the issuer in reliance on the block trade exception.6 Instead, the broker/dealer can rely on the exception only when a seller offers a block of securities for sale.
Furthermore, Stephens' experience with medium and small issuers indicates that the Commission's concern that issuers will be able to manipulate the market for their securities through block trades is not borne out in the market. While block trades are frequent in the case of the largest issuers, they become less so as a company's size, trading volume, and market capitalization decrease, due to the lower level of institutional investment in smaller companies. As a result of this diminished institutional involvement and the corresponding decrease in the availability of blocks to buy and sell, medium and small issuers have less ability to "dominate the market for their securities" through block purchases under a Rule 10b-18 repurchase program. Of course, medium and small companies do have some institutional shareholders. As more fully set forth immediately below, the block purchase exception allows such issuers to absorb block sales by institutional shareholders and, thereby, avoid the distortion of the market in their securities that could otherwise occur, which benefits the company's other shareholders.
The Elimination of the Block Purchase Exception Would Be Detrimental to Medium and Small Issuers
Stephens believes that the elimination of the block purchase exception would be detrimental to medium and small issuers, as they would be unable to rely on the 25% volume limitation to absorb large institutional block sales. Stephens finds that institutional investors purchase and sell only in block transactions, so that, when an institutional investor decides to realign its portfolio, it will do so through block transactions. In Stephens' experience, a principal reason that many medium and small issuers maintain a Rule 10b-18 repurchase program is in order to absorb institutional sales in the interest of the company's other investors who would be harmed by the market price decline that would result if the institution's block must be sold in many small transactions. Unlike the case of large issuers, where there is generally a ready market for large blocks of stock, in the case of medium and smaller issuers, there are often no purchasers for a block other than the issuer itself. The block purchase exception is necessary to absorb institutional sales in the securities of such issuers because the size of a single block or the aggregate of several blocks sold on the same day will often exceed the 25% volume limitation of Rule 10b-18.
An example might prove instructive. Consider an issuer with 20 million shares outstanding, an ADTV of 100,000 shares and, therefore, a volume limitation of 25,000 shares. It is not unusual for an institutional shareholder to hold as much as 5 percent of a company's stock, which in this case would represent one million shares. In the event that such an institutional shareholder opted to liquidate its position in the company, Stephens' experience is that it would do so in several blocks ranging in size from 10,000 shares to 50,000 shares or more. Under Rule 10b-18 as proposed to be amended, the issuer could rely on Rule 10b-18 to absorb on a single day only one or two blocks that did not aggregate more than 25,000 shares. The issuer, therefore, would be unable to prevent the downside pressure on the market price of the company's stock that would result as the institutional investor was forced to sell the majority of its one million share position in small transactions over several days.
Stephens notes that in justifying the elimination of the block exception, the SEC states "eliminating the block exception would not impede an issuer's ability to repurchase within the safe harbor as there is no limit on the number of days over which repurchasing can be conducted."7 Stephens' experience, however, is that an institutional shareholder wishing to liquidate a large block would not want to sell over a long period of time and instead would be forced to sell the block into the market through a series of smaller sales, the very scenario which the Commission sought to address through its initial adoption of the block exception.
Block Purchases Appropriately Stabilize the Market
The SEC cites three studies in 1987, 1989 and 1990 in support of its statement that "[e]conomic studies have shown that block trades effected in the normal course of trading can affect a security's price."8 Stephens believes that, if anything, this conclusion is a basis for retaining the block purchase exception since, as described above, block sales can "move" a market just as block purchases can. Stephens does not agree with the Commission's speculation, based on the referenced studies, that "investors could be misled about the integrity of the securities trading market as an independent pricing mechanism"9 because the very premise that the securities trading market is in an absolute sense an "independent pricing mechanism" is flawed.
The SEC and the securities markets have adopted many forms of pricing controls, including passive market making, stabilizing, short sale, up tick, and locked and crossed market rules. Although the SEC's study of the October 1987 Market Break questioned whether it was appropriate for large issuers to be "the predominant buy market force in their securities," 10 Stephens believes that since the Market Break the SEC and market participants have considered Rule 10b-18 to be an important mechanism for retarding a general market decline in the case of severe market conditions. Stephens urges the SEC to not view negatively an issuer being "the predominant buy market force" in a time of severe market decline,11 since the issuer can only purchase as a contra-party to block trade sales by institutional investors that would otherwise have a severe, negative impact on the issuer's market price. In Stephens' view, the SEC's study of the October 1987 Market Break demonstrates that large issuers that purchased in excess of 50% of the company's trading volume required the block trade exception outside of the Rule's volume limitation in order to absorb significant block sales when there was no other buyer.
Stephens also notes that the SEC appeared to recognize the important stabilizing force of Rule 10b-18 when it issued two exemptive orders (the "Emergency Orders") following the September 11, 2001 terrorist attacks to ensure that issuers would be able to rely on Rule 10b-18 to "absorb undue order imbalances," stating that "Purchases by registrants of their own securities can represent an important source of liquidity during times of market volatility."12 In light of the SEC's willingness to facilitate issuers' reliance on Rule 10b-18 when the stock markets reopened after the September 11, 2001 terrorist attacks, Stephens does not understand the basis for the SEC's proposal to eliminate the block trade exception. The SEC has had experience during the October 1987 Market Break and the post-September 11, 2001 reopening of the market to determine that the block trade exception, in fact, operates efficiently to stabilize the market in severe market-wide declines that are harmful to investors. Stephens believes that in the case of isolated market reversals primarily affecting an industry or industry segment, as well severe market conditions affecting companies in many different industries or the market as a whole, the presence of the issuer's buying power in the market to absorb institutional block sales also helps retail sellers obtain a better price for their securities than would otherwise be possible.
The 25% and 100% Volume Limitations Will Not Address Volatile Markets and Severe Market-Wide Declines
Stephens believes that, as a practical matter, it is necessary to retain the block purchase exception because the 25% and proposed 100% volume limitations are inadequate to absorb unusually high levels of block sales in the case of volatile markets, market-wide declines following a market-wide trading suspension, and other severe market-wide declines. Stephens' experience is that the market generally and a company's stock specifically can experience low volume for a number of weeks and then be subject to high volatility, coupled with much higher trading volumes of two to three times normal volume. Further, it is always the case that a severe market-wide decline (whether or not following a market-wide suspension) is accompanied by a significant increase in trading volume that is far in excess of the market's average daily trading volume. In such cases, Stephens believes that the current 25% and the proposed 100% volume limitations are likely to be woefully inadequate as they are calculated against an average trading volume that is at a much lower level.
With respect to the 25% volume limitation, Stephens also believes that a number of events, short of a market-wide suspension, can have a highly negative affect on the market generally or the securities in a particular industry and be accompanied by unusually high trading volume. In such situations, Stephens' experience is that a company would be unable to absorb institutional block sales within the 25% limitation. Recently, we have seen events surrounding potential war with Iraq, statements and actions by the Federal Reserve Board, and revelations of corporate misconduct, among others, that resulted in significant market volatility with accompanying market imbalances. Stephens believes, therefore, that the block trade exception continues to be necessary so that issuers can absorb the volume of institutional sales that occur in such situations outside of the 25% limitation.
With respect to the proposed 100% volume limitation following a market-wide trading suspension, Stephens believes that the rule proposal fails to recognize that it was the block purchase exception that allowed issuers to absorb large block trade sales in compliance with Rule 10b-18 amid the considerable confusion and tension that occurred during the October 1987 Market Break and following the September 11, 2001 market-wide trading suspension. Stephens' experience is that most issuers relied on the block purchase exception to effect Rule 10b-18 purchases following the September 11, 2001 trading suspension when the SEC's Emergency Orders were in effect in order to ensure compliance with Rule 10b-18 in a time of difficult trading circumstances (including difficulties in quickly obtaining historical ADTV information on numerous securities). Retaining the block purchase exception, Stephens submits, is the best way to allow issuers to repurchase their securities in such difficult circumstances.
Block Purchases Facilitate Rule 10b-18 Compliance
Stephens believes that the practical benefits of the block purchase exception outweigh the Commission's theoretical concerns. A key element of the block purchase exception is its simplicity. An issuer and its broker/dealer can rely on a clear measure of volume compliance that operates on a trade-by-trade basis, regardless of the individual company's ADTV or the time when or circumstances under which the purchase is executed.
In comparison, compliance with the 25% and proposed 100% volume limitations present several difficulties akin to those experienced by broker/dealers that engage in passive market making under Rule 103 of SEC Regulation M. The first of these is the difficulty of maintaining an accurate calculation of a company's ADTV over the long period of time that a Rule 10b-18 repurchase plan is in effect. Since the ADTV calculation is based on transactions during the four calendar weeks preceding the week in which the Rule 10b-18 purchase is effected, the applicable ADTV will change every week for an on-going Rule 10b-18 repurchase plan. It also may be difficult for issuers and broker/dealers to quickly obtain accurate historical ADTV information with respect to large numbers of securities in the tense environment of a severe market-wide decline or a break in the operation of the markets.
In addition, Stephens notes that it can be difficult for a broker/dealer to maintain an accurate count of shares purchased by the many representatives on the trading desk in the hectic atmosphere of a severe market-wide decline in order to ensure compliance with the volume limitation. Unlike SEC Rule 103 of Regulation M, moreover, Rule 10b-18 does not address whether the specific transaction that takes the broker/dealer over the daily volume limitation is considered to be a violation of the rule. The SEC should recognize that broker/dealers can have difficulties monitoring the purchase limitation for passive market making purposes and that NASD, Inc. was required to establish multiple rules and functions within the organization to help broker/dealers effect compliance with that rule. Stephens believes, therefore, that the SEC should anticipate that, if the SEC eliminates the block purchase exception, inadvertent violations of the volume limitations are more likely to occur and the costs of regulation and compliance will increase.
* * * *
For the reasons stated herein, Stephens respectfully requests that the Commission amend its proposal to permit issuers to make Rule 10b-18 purchases in compliance with a block purchase exception to the 25% and proposed 100% volume limitations. If the SEC wishes to discuss this submission, please contact the undersigned or David A. Knight, Executive Vice President and General Counsel, Stephens Inc., at (501) 377-2573.
cc: David A. Knight