Brian E. Morrissey

82 Norristown Rd.

Blue Bell, PA 19422

(215) 628-0140

bmorriss@law.vill.edu

Jonathan G. Katz

Secretary

Securities and Exchange Commission

450 Fifth Street, NW

Mail Stop 6-9

Washington, DC 20549

Before the

 

U.S. SECURITIES AND EXCHANGE COMMISSION,

 Washington, DC 20549



In the Matter of )
)
PUBLICATION OR SUBMISSION OF )

File No. S7-5-99

QUOTATIONS WITHOUT SPECIFIED )
INFORMATION )
)


 Comments of Brian E. Morrissey(1)

  

___/s/________________

 Brian E. Morrissey

82 Norristown Rd.

Blue Bell, PA 19422

April 7, 1999



TABLE OF CONTENTS

 I. Introduction

II. The Internet

III. The Effects of the Amendments

IV. Exclusions to the Rule

V. Liability of Broker-Dealers

VI. Conclusion

SUMMARY

1. The reproposed amendments should be enacted in order to combat fraud and manipulation of microcap securities.

2. The benefits of the amendments include increased awareness on the part of broker-dealers when acting as market makers. This will ensure greater reliability for investors when viewing the quoted price of microcap securities.

3. The responsibility placed on broker-dealers is minimally burdensome in light of the resulting benefits. One particular factor that will lessen the burden of broker-dealers will be the availability of information on the Internet to aid in the gathering of information.

4. The reproposed amendments are fair in that the SEC has responded to the concerns of those who submitted comments by making changes in the proposed amendments where warranted.

  

I. Introduction

A. The reproposed amendments should be enacted.
The reproposed amendments to Rule 15c2-11 will be a beneficial addition to the Securities Exchange Act of 1934.(2) Rule 15c2-11 governs the publication of quotations for securities in a quotation medium other than a national securities exchange or Nasdaq.(3) It is intended to prevent broker-dealers from fraudulently manipulating microcap securities.(4)

B. Microcap securities are vulnerable to manipulation.
The Securities and Exchange Commission (SEC) is concerned with microcap securities for two reasons. First, there is a lack of information about microcap securities. Second, microcap securities are thinly traded. With the current influx of new, unseasoned investors, microcap fraud has escalated into a huge area of fraud. Now, the SEC wants to close some of the loopholes commonly used by microcap manipulators.

Microcap securities are particularly vulnerable to manipulation by brokers. The SEC characterizes microcap securities as securities having "low share prices and little or no analyst coverage."(5) Such securities are usually thinly traded through either the OTCBB or the "pink sheets", or quoted in alternative trading systems.(6) Microcap securities can also be listed on securities exchanges or Nasdaq.(7) A major problem with microcap securities is the lack of information available. This can be the case, for example, when a company is not subject to the SEC's periodic disclosure requirements. Because the securities are thinly traded and there is not much information available to investors, microcap securities are more easily manipulated by unscrupulous brokers. Such brokers will push certain securities to investors in order to generate interest and drive up the price. When the broker finally cashes out their own shares at the inflated price, the hapless investors are left holding the shares which have plummeted back to reality.

C. Microcap manipulators use Rule 15c2-11 as a tool of their illegitimate trade.
Microcap fraud can be perpetrated by a number of methods. For example, The S-8 form has been used as a tool to circumvent the prospectus requirement by passing the shares through "consultants".(8) In addition, Regulation S has been used to avoid registering shares by selling them offshore, then bringing the shares back into the U.S. market.(9) The SEC has addressed these problems separately.

In addition, Rule 15c2-11 is one of the favorite tools used by microcap con-artists. When hyping a microcap stock, con-artists like to have quotes from several market makers, implying that the stock is well followed. The problem is that many market makers do not research the companies whose quotes they publish. This is a result of the low standards currently in place under Rule 15c2-11. As Rule 15c2-11 stands now, market makers in bulletin board or pink sheet securities have to look over the basics of the company at least once a year-- a fairly low standard. Furthermore, once a quote has been out for 30 days, other market makers can "piggyback" -- by publishing the same number even if they don't know anything about the company. The SEC wants to make subsequent market makers review certain information before they offer quotes.

D. The SEC has reproposed Rule 15c2-11 in order to curtail abuse.
Thus, the SEC has proposed a revision of Rule 15c2-11, which deals with market makers' awareness of the issues in which they are dealing. The concern the SEC has with market makers is that quotations are often integral to fraudulent schemes involving microcap securities. Retail brokers "hyping" a microcap security may point to a market maker's quotation as indicating the security's value to a potential customer. This can create problems because many market makers may publish quotations for unlisted securities without reviewing any information about the issuer. Microcap securities often are thinly-traded. Issuers of microcap securities may have minimal or no assets. Many of these securities are traded in the unlisted over-the-counter market. In other words, they are not listed on an exchange or NASDAQ, but instead are quoted in systems like the NASD's OTC Bulletin Board or the National Quotation Bureau's "Pink Sheets".

E. The reproposed amendments eliminate the practice of "piggybacking."

 Under the current Rule 15c2-11, the first broker-dealer to publish a priced quotation must obtain and review the Rule's required information. The scope of the current rule is limited to apply only to the first market maker publishing a quotation. This is a result of the statutory scheme in which the piggyback exception basically swallows the rule. Under the current Rule's piggyback exception, a broker dealer may publish quotations of covered OTC securities without reviewing current issuer information if the security is already the subject of frequent quotations in the same interdealer quotation system. The piggyback exception is broad, allowing any subsequent market maker to publish quotations in the security indefinitely, unless there is a "significant lapse in quotation activity."

The reproposed amendments will require market makers to review issuer information before initiating priced quotes for unlisted securities. The practice of "piggybacking" will be eliminated. In short, they will have to "stop, look and listen" before starting to place priced quotes for an unlisted security in a quotation system. Of course, as under the current rule, the first market maker to publish a quote, priced or unpriced, will still be required to review the specified issuer information.

F. Rule 15c2-11 imposes a review requirement for broker-dealers.
 The amendments to Rule 15c2-11 would require broker-dealers to obtain and review issuer information before publishing a priced quotation and to provide such information to customers upon request. Market makers publishing priced quotations will have to review updated information annually. Market makers will also have to document their review and record information regarding any significant relationships that they have with the issuer or others, including the receipt of any compensation to make a market. As explained above, the proposed amendments will also eliminate the piggyback exception. Under the amendments, no broker-dealer, directly or indirectly, may publish the described kinds of quotations for a security in any quotation medium, without first complying with the Rule's provisions. Nevertheless, there are a number of exemptions to Rule 15c2-11 which will be discussed later.

 Under the current rule, the first broker quoting a microcap security can be characterized as an underwriter. Thus, the first broker assumes a fair degree of culpability in these situations if he is not carefully in his choice of companies. Under the reproposed amendments, subsequent brokers in will be as equally exposed to liability as the first broker.

II. The Internet

A. There are two elements to perpetrating microcap fraud.
  There are two elements to the perpetration of microcap fraud. First, interest must be generated about a security. This, however, may not be enough to entice many investors. Such investors realize the dangers of relying on a "hot tip" without doing any additional research. One thing they will look for is to see if there is a market for which to trade the touted security. This is where the second element of the fraud comes in. The market makers publish quotations for the microcap securities. This gives investors something concrete for which to evaluate. They may even see the price and the demand for the security increase as they watch. At this point, the investor is usually ready to purchase. What the unseasoned investor is about to learn is that he or she just got swindles in a classic "pump and dump" scheme. The pump is the synthetic 'hype' surrounding the security generated by the actions of the unscrupulous brokers and resulting in the price increase. Soon after these brokers and their cronies dump their securities by selling them and ceasing their efforts to tout such stock. The result is that the unwitting investors are left holding the bag containing securities for which they paid entirely too much.

B. The Internet has facilitated the perpetration of fraud on investors.
 The Internet has provided securities shysters with a great tool for perpetrating the first part of this fraud. Through bulletin boards, chat-rooms, web pages and e-mail, the Internet is an efficient and inexpensive way to create interest in a security. For example, a web page may tout the latest sure-thing stocks. Similarly, spam e-mail may tell recipients to act quick in order to profit from stock that is ready to take off. This type of fraud is a whole other issue the SEC has been pursuing. Relevant to Rule 15c2-11 is the fact that microcap fraud has become even easier to perpetrate. Thus it makes sense to approach it from all possible angles. Rule 15c2-11 addresses the second common component of microcap fraud -- market making.

C. Rule 15c2-11 is a proper response to the increased problem of fraud.
 Rule 15c2-11 addresses the role that market-makers play in microcap fraud. Market makers may be knowing participants in the fraud or merely unknowing facilitators. Regardless, Rule 15c2-11 is indifferent to the mental state of the broker. Rather, it imposes affirmative steps which must be taken by brokers. Although brokers may complain about their increased exposure to liability, the effect of Rule 15c2-11 is to place the responsibility on the one person who is in the best position the prevent the fraud. If brokers do their homework before listing a security, they should have nothing to worry about.

D. The Internet is part of the solution to the increased fraud.
While the Internet is part of the problem with microcap fraud, it is also part of the solution. Under the reproposed amendments, broker-dealers have an affirmative duty to gather and review certain information before publishing quotations. There are four basic components to this duty:

1 Review The broker-dealer must review the Rule's specified information
2 Determine The broker-dealer must determine that it has a reasonable basis for believing that the information is accurate in all material respects and was obtained from reliable sources.
3 Record The broker-dealer must record the following-- (1) the date the information was reviewed, (2) the sources of the information, and (3) the name of the person responsible for the firm's compliance with the Rule.
4 Preserve The broker-dealer must preserve the Rule's specified information in accordance with Rule 17a-4.


While this may seem rather burdensome, the Internet will help to facilitate the duties. For reporting issuers, broker-dealers can consult on-line databases such as EDGAR. In addition broker-dealers may consult federal or state databases for information about issuers of covered OTC securities. Broker-dealers publishing quotes for securities of exempt financial institutions may contact their primary bank regulatory agency to obtain the financial institution's regulatory reports. Internet sites exist for the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation.

 For non-reporting issuers of covered OTC securities, the SEC has noted the desirability of having a database containing Rule 15c2-11 information. Such a database would be an efficient source of information regarding issuers that do not follow a policy of public disclosure. While the SEC and the NASD are unable to take responsibility for creating and maintaining a Rule 15c2-11 repository, the SEC has encouraged private sector initiatives to address the issue.

E. Rule 15c2-11 relaxes the preservation requirement for Internet information.
 The proposed amendments also relax the preservation requirement with regard to information obtained over the Internet. The preservation requirement of the amendments will be contained in Rule 17a-4 rather that in Rule 15c2-11. Rule 17a-4 requires broker-dealers to preserve certain information. The proposed amendments will add Rule 15c2-11 information to the list of other information already required under Rule 17a-4. If Rule 15c2-11 information is obtained through EDGAR, a federal or state electronic information system, or an information repository, the requirements of preservation are reduced. As long as the broker-dealers document their review of the information and the information is accessible through such a system for the required time period in Rule 17a-4, the broker-dealers will not have to preserve this information separately.

 

III. Effects of the Reproposed Amendments

The SEC's reproposed amendments are more narrow in scope than the original proposed amendments. The amendments now focus on particular securities the SEC believes are more prone to fraud and manipulation. For example, the reproposed amendments now exclude non-convertible debt, non-participatory preferred stock and investment-grade asset-backed securities from the coverage of Rule 15c2-11.(10)

In response to submitted comments, the SEC has limited the scope of the Rule to:

1. priced quotations (exception: If a broker-dealer is giving the first quotation for a covered OTC security, the Rule applies to unpriced quotations as well).

2. those securities that the Commission believes are more likely to be the subject of improper activities (the Rule no longer applies to securities that have a substantial trading price or that meet a minimum dollar value of average daily trading volume).

Another area which the reproposed amendments differ from the original proposed amendments is in the entities to which a broker-dealer must provide information. Under the original proposal, broker-dealers were obligated to provide the Rule 15c2-11 information to anyone making such a request. Under the reproposed amendments, broker-dealers must provide such information only to requests made by:

1 A current customer
2 A prospective customer
3 An information repository
4 Another broker-dealer


The current Rule does not specify the status of the person who must conduct the review on the broker-dealer's behalf. The reproposed Rule requires the broker-dealer to make a record of the person at the firm who is responsible for the broker-dealer's compliance with the Rule's provisions.

The final difference is that the amendments do not require broker-dealers to provide information that is accessible through EDGAR, any other federal or state electronic information system, or an information repository.

In general, the effects of the amendments are:
1 Elimination of the piggyback exception.
2 Expansion of the information required for issuers that do not file periodic reports with the Commission (e.g., non-reporting issuers).
3 Broker-dealers are required to make the issuer information available to anyone who requests it.


 

IV. Exclusions to the Rule

 

Although the amendments do increase the scope of Rule 15c2-11, there are a number of exclusions from the Rule:

1 Volume of security Any securities that have a worldwide average trading volume of at least $100,000 during each month of the six full calendar months immediately preceding the date of publication of a quotation. A convertible security can meet this threshold on the basis of its underlying security.
2 Price of security Any securities with a bid price of at least $50 per share.
3 Assets of Issuer Any securities of issuers with net tangible assets in excess of $10,000,000 (demonstrated by audited financial statements)
4 Category Exemptions a) Any non-convertible debt or non-participatory preferred stock

b) Any asset-backed securities that are rated as investment grade by at least one nationally recognized statistical rating organization.



V. Main Concerns of Commentators

A. Will the liquidity of microcap securities be adversely affected by the amendments?
One of the stated goals of Rule 15c2-11 is to give investors more confidence in market makers' quoted prices of microcap securities. This will lead to an increase in microcap liquidity as investors will be less likely to be defrauded. Some market makers may be reluctant to quote microcap securities as a result of their increased duties under the amendments. Nevertheless, as the burden of gathering Rule 15c2-11 lessens as a result of the Internet, more broker-dealers will resume their roles as market makers. In addition, these market makers will be better informed.

B. Will broker-dealers face unlimited liability as a result of the amendments?

Broker-dealers will have no obligation to continuously update their Rule 15c2-11 materials. The broker-dealer's review obligations under the Rule occur only at the specific times identified in the Rule. Broker-dealers will not be held responsible as long as they fulfill their duties under the amendments. In fact, Rule 15c2-11 should act as a guide for broker-dealers questioning whether they are in compliance or not.

In addition, the SEC has provided broker-dealers with a great deal of guidance for the review process. For example, the SEC has declared a number of situations "red flags" for which broker-dealers should not publish quotes without addressing. One such "red flag" is a commission trading suspension.(11) Broker-dealers publishing quotes once a trading suspension terminated must satisfy the requirements of Rule 15c2-11.(12)

VI. Conclusion

The SEC should enact the reproposed amendments. The amendments are intended to enhance the integrity of quotations for securities in the microcap sector; to improve the quality of information about smaller, lesser-known issuers; and to foster greater access to such information by investors. Clearly the general intent of the amendments, to combat microcap fraud, is appropriate. In addition, the method of implementing the measures is also appropriate. The burden is placed on those who are in the best possible position to prevent fraud, the broker-dealers. Although this burden will require additional time and money, there are a number of factors which lessen the burden. First, the Internet will ease the process of gathering information. Second, broker-dealers may charge for reasonable expenses incurred in producing and forwarding Rule 15c2-11 information. Third, the SEC has responded to the comments from the initial proposed amendments and responded accordingly. As some concerns were expressed about having to respond to all information requests, under the reproposed amendments, broker-dealers must respond only to information requests made by certain individuals. As other concerns were expressed about having to supply publicly available information, the SEC has limited the information required to be supplied to information not available through either federal or state information systems (e.g., EDGAR) or an information repository.

1. The author is a third-year law student at Villanova University School of Law.

2. See Securities Exchange Act Release No. 34-41110 (March 2, 1999), 64 FR 11124 (Reproposed Rule: Publication or Submission of Quotations Without Specified Information), available through the SEC website at <http://www.sec.gov/rules/proposed/34-41110.htm>.

3. 17 CFR 240.15c2-11.

4. Id. See also, 17 CFR 240.10b-5 (exemplifying another antifraud provision under which broker-dealers may be subject to liability).

5. See supra note 1, Release No. 34-41110 at 11125 n.1 (noting that the term "microcap securities" is not defined under the federal securities laws or regulations).

6. OTCBB refers to the over the counter bulletin board operated by the National Association of Securities Dealers (NASD). "Pink sheets" are referred to as such because of the color of the pages used to list them by the National Quotation Bureau (NQB).

7. However, Rule 15c2-11 does not apply to securities listed on a national exchange or Nasdaq.

8. See Michael Brush, "Turning Up the Heat on Scamsters" Money.com Thursday, February 26, 1998 <http://pathfinder.com/money/moneydaily/1998/980226.moneyonline.html> ("The SEC originally created "S-8" forms to give companies a quick way to register shares used to compensate employees."). The SEC figures that because employees already know about their company, no prospectus is needed. Id. In 1990, the SEC decided to let companies use S-8s to register shares meant for paying consultants also. Id. This created a loophole. Id. Manipulators quickly figured out that Form S-8 could be used to register shares for "consultants" whose only real "service" was to turn around and sell those shares to the public. Id. In other words, they found a way to get new shares in the market without having to file a prospectus. Id. The SEC has adopted amendments to Form S-8 that restrict the use of Form S-8 for the sale of securities to consultants and advisors. See Securities Act Release No. 33-7646 (February 19, 1999), available through the SEC's website at <http://www.sec.gov/rules/final/33-7646.txt>.

9. See supra, note 8, "Turning Up the Heat on Scamsters." Regulation S (Reg. S) lets companies avoid registering shares with the SEC, as long as those shares are to be sold offshore. Id. The SEC's reasoning is that if the stock is going to another country, let that country worry about it. Id. However, some brokers have been abusing this rule by bringing shares sold offshore back into the U.S. markets. Id. Therefore, the SEC want to make "Reg. S" securities like any other restricted securities, meaning that they can't be resold in the U.S. without having been registered. Id.

10. See The Bond Market Association, Legal & Regulatory Issues: Corporate Bond Division, SEC Rule 15c2-11 <http://www.bondmarkets.com/regulatory/corp.shtml> ("The Association submitted a comment letter which strongly opposed the Rule's application to debt securities."). This outcome reflects a widely held view, among market participants as well as regulators, that the Rule is unnecessary for, and was not intended to apply to, debt market transactions. Id.

11. Information regarding recent trading suspensions orders can be obtained either by telephone at 800-SEC-0330 or through the SEC website at <http://www.sec.gov/enforce/tsuspend.htm>.

12. NASD Marketplace Rule 6740 works in conjunction with Rule 15c2-11. See NASD Regulation, "Trading & Market Making: Compliance With SEC Rule 15c2-11 And NASD Marketplace Rule 6740 Following An SEC Trading Suspension" <http://www.nasdr.com/3070_9903.htm> ("It has come to the attention of NASD Regulation that following recent trading suspensions some members have been entering quotations into quotation mediums without complying with SEC Rule 15c2-11 and NASD Marketplace Rule 6740."). In this article, the NASD reminded its members of their obligations under SEC Rule 15c2-11 and NASD Marketplace Rule 6740 following trading suspensions imposed by the SEC. Id. In particular, the NASD stated that members must fully comply with the requirements of those rules before entering quotations into any "quotation medium". Id. The NASD explained that SEC Rule 15c2-11 establishes requirements for the publication and submission of quotations for certain over-the-counter securities on a "quotation medium" (as defined below). Id. Therefore, unless a member can rely upon an exception to 15c2-11, NASD Marketplace Rule 6740(a) prevents members from initiating or resuming the quotation of a non-Nasdaq OTC security without first demonstrating compliance with the information maintenance requirements of Rule 15c2-11. Id.