May 6, 1999
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street NW
Washington, D.C. 20549
Re: Proposed Amendments to Rule 15c2-11; File No. S7-5-99
Dear Mr. Katz:
The Federal Regulation Committee and Self-Regulation Committee ("the Committees") of the Securities Industry Association ("SIA") appreciate the opportunity to submit this comment letter in response to the reproposed amendments to Rules 15c2-11 and 17a-4 ("the Reproposal") of the Securities Exchange Commission ("Commission" or "SEC"). The Committees strongly support the need to combat and extinguish fraudulent activity in the market for micro-cap securities, and applaud the Commission's ongoing efforts toward this end. Fraudulent activities in any market sector attack the foundations of our Nation's capital markets, the most vibrant and successful markets in history. The securities industry has a vital interest in eliminating such conduct. However, it is also essential to the future success of our markets that they not be encumbered with regulatory requirements that are ineffective, or even counterproductive, in combating fraud.
The Reproposal is significantly better than the Commissionís 1998 proposed amendments to Rule 15c2-11 ("the 1998 Proposal") in one important respect -- it excludes from the coverage of Rule 15c2-11 most types of over-the-counter ("OTC") securities as to which concerns about "microcap" fraud are inapplicable. The Committees strongly support this carve-out, and believe that it should be promptly applied by interpretive release or no-action letter to existing Rule 15c2-11. Regrettably, in most other respects the Committees do not believe that the Reproposal would be an effective approach to attacking microcap fraud, and we fear that the many commenters who criticized the earlier iteration of the Commission's approach may be correct that it could in fact make these markets even more prone to abuse. The Reproposal does not adequately address many of the concerns that virtually all market participants, including the securities industry, raised with regard to the original proposal ("the 1998 Proposal").
The SEC's Initiatives on Microcap Fraud.
The issuers of microcap securities are typically small companies that offer important growth opportunities to investors, and that are important job-creating engines of our Nation's economic growth. These issuers' access to the securities markets provides them with access to capital that would otherwise be limited. At the same time, microcap securities have proven susceptible to abusive conduct by dishonest promoters, using high-pressure sales tactics to effect "pump and dump" and similar illegal schemes. Such conduct harms not only investors, but the legitimate issuers who depend on these markets and the reputable market-makers who provide the liquidity without which these markets would scarcely exist.
The Reproposal marks one of many initiatives the Commission has launched to address concerns about abuses in the microcap markets. On the enforcement front, the SEC has filed numerous actions, and has worked closely with criminal prosecutors in bringing a number of criminal actions. The Commission's examination program has concentrated resources for cause examinations of broker-dealers and transfer agents in areas of the country where microcap fraud is thought to be most common. Like SIA, the SEC has an active program to promote investor education. The Commission has also adopted regulatory changes to this end, such as amendments to Form S-8 under the Securities Act of 1933 and Regulation D under the Securities Exchange Act of 1934.
The 15c2-11 microcap initiative has proven to be highly unpopular, as the comment letter file to the Commission's 1998 Proposal reflects. In the eyes of most of the commenters, the proposal, to greatly increase the obligation of market-makers to review financial information about issuers, is counterproductive. The chief concern expressed in comment letters by a wide range of issuers, investors and market-makers is that the proposal would create substantial liability concerns and regulatory costs on market-makers, discouraging them from continuing to make markets in microcap securities. This in turn, commenters feared, would lead to less liquid, less transparent markets even more vulnerable to abuse. Moreover, other commenters, particularly the Committees, pointed out that the proposals would create significant new burdens on OTC markets, such as corporate debt markets and markets for major foreign issuers, where "microcap fraud" concerns did not apply.
In the Reproposal, the Commission responds to some of these concerns by defining the universe of microcap securities, excluding from its coverage many categories of securities as to which the concerns about microcap fraud do not apply. This is generally consistent with one of the principal suggestions of our comment letter on the 1998 proposal. As we discuss in greater detail below, the Committees applaud these exclusions and, subject to a few revisions, we urge that they be applied by no-action letter or interpretative release to existing Rule 15c2-11. The Reproposal also greatly reduces its application to unpriced quotations, also consistent with the Committees' suggestion. In addition, the Reproposal seeks to ease Rule 15c2-11's recordkeeping requirements by liberalizing the ability of broker-dealers to use electronic filings to meet their review obligation. The Committees support these changes.
In other respects, the Reproposal is either much the same as the 1998 proposal, and the concerns raised with that proposal still obtain, or contains new requirements that raise fresh concerns. In particular, the concerns that the proposal would impose on market-makers a regulatory oversight function, leading to significant increases in their costs, as well as litigation exposure, have not been addressed at all. Moreover, the Reproposalís list of "red flags" that would engender heightened review of issuer information pose substantial new concerns. Consequently, it is not surprising that, as of the date of this letter, the comment letters posted on the SEC's Internet web site are running approximately 40 to 1 against the proposal. This record is, in our view, a completely inadequate basis for making the statutorily required finding that the reproposed amendments are a means "reasonably designed" to prevent fraudulent, deceptive, or manipulative acts or practices.
In our previous letter we indicated that we could give conditional support for some aspects of the proposal if the SEC concluded that it was necessary after carefully considering the possibility that, rather than diminishing bad conduct, enhanced requirements might drive legitimate market participants out of some OTC markets, or might drive some OTC market activity into venues that are far less susceptible to SEC oversight such as Internet or offshore markets made by foreign broker-dealers.
Unfortunately, as discussed below, the release accompanying the Reproposal gives almost no attention to this concern, even though it was amplified by many other commenters across the spectrum of market participants. Our review of other commenters has convinced us that our concerns were far from overstated. Moreover, the Reproposal contains new requirements that we believe heighten the concerns that the overall effect will be less liquid markets more vulnerable to abuse. Therefore, the Committees reluctantly conclude that on the whole the Reproposal is a step backwards for investor protection in microcap markets, and we urge the Commission not to adopt the reproposed amendments to Rules 15c2-11 and 17a-4. At the end of this letter we outline other steps, in addition to the ongoing SEC initiatives in this area, that we think are more productive avenues for attacking microcap fraud.
Our concerns with the Reproposal fall into three major categories. First, the Commission has seriously understated the costs of the proposal, overstated its benefits, and given inadequate analysis to its adverse effect on efficiency, competition and capital formation. Secondly, we believe that the Reproposal is based on a fundamental misapprehension of the nature of market-making. Third, the Reproposal's suggested "red flags," which would entail heightened review by the market-maker, would create new regulatory problems.
Impact on Competition and Cost-Benefit Analysis.
The Reproposal's analysis of its impact on efficiency, competition and capital formation is regrettably cursory, particularly given how importantly those considerations bear on whether the proposal will ultimately contribute to, or detract from, investor protection. The Reproposal also significantly underestimates many of the costs associated with the proposed amendments to Rule 15c2-11, and overlooks some costs entirely. At the same time, the benefits that the Reproposal posits are based on faulty assumptions about the role of independent market-makers in "facilitating" microcap fraud.
Impact on Efficiency, Competition and Capital Formation. Contrary to the statement in the Reproposal that it "would not have any anti-competitive effects that are not necessary or appropriate in the public interest," the Committees believe that there are significant adverse effects that the Commission does not mention. As the discussion below of costs indicates, the Reproposal would impose significant new costs on market-makers, which could result in market-makers withdrawing from many securities. These effects will impact liquidity for securities, with spillover harmful effects on the ability of small issuers to raise capital on the OTC markets.
There are approximately 8300 issuers listed on the NASD's OTC Bulletin Board or in the Pink Sheets, with estimated market capitalization of around $400 billion. Many of these securities are quoted by a small handful of market-makers. The significant costs that the Reproposal would incur would lead to a significant decline in competition among market-makers for many of these securities.
Nowhere in its discussion of the impact on efficiency, competition and capital formation does the Commission mention any of these concerns. In addition, since many entrepreneurial innovations arise out of issuers that begin as small-capitalization companies, the long-term economic impact on the U.S. economy, while immeasurable, could be important. The Reproposal does not closely consider the impact that it could have on small companies and their ability to raise capital, and it is questionable whether the Commission's classification of the Reproposal as a non-major rule is accurate. We recommend that the Commission consult with the Office of Advocacy of the Small Business Administration as part of its evaluation of the potential costs involved. That review should better enable the Commission to address the question that it poses as to whether the proposal would have a $100 million or greater effect on the economy.
The Commission's discussion of costs states that it believes that a broker-dealer would require a maximum of 4 hours to collect, review, record, retain and supply to the NASD the required information pertaining to a reporting issuer, and a maximum of 8 hours to do the same for a non-reporting issuer. The Commission assigns an average cost of $40 per hour (blended cost for clerical and supervisory compliance staff) to obtain and review the required information. The Committees disagree with these estimates.
Review Costs. The Commission's average cost of $40 per hour seems to assume that the review will be largely performed by clerical staff. However, in our view in many instances the review would have to be largely conducted by highly trained professionals at a much higher rate of compensation than the Commission anticipates. This would be especially true where any of the numerous "red flags" highlighted by the Reproposal are present. It is important to note that the Commissionís cost analysis does not separately identify and discuss red flag reviews. We believe that this is a serious omission. As discussed more extensively on pages 12-16 below, in situations involving red flag reviews, the level of review that responsible broker-dealers would be compelled to conduct to satisfy the Commissionís open-ended criteria would be vastly beyond the figures that the Commission cites.
Our view is buttressed by an analysis commissioned by the law firm of Orrick, Herrington & Sutcliffe ("Orrick") of the procedures called for under the Reproposal, and their attendant costs. The study, conducted by the firm of Pricewaterhouse Coopers LLP (the "PWC Study"), attempts to develop a list of steps that a broker-dealer would likely have to take to meet the explicit requirements of the Reproposal, as well as other steps that, while not explicitly stated in the Reproposal, logically result from its requirements.
The PWC Study breaks the review requirement into four general procedures: (i) identifying the securities that would be covered under the Reproposal; (ii) collecting, recording, retaining and supplying information concerning issuers; (iii)reviewing information; and (iv) submitting information to the NASD. In addition, the study identifies other recurring and initial costs. The study attempts to break down costs based on a hypothetical dealer that publishes quotations in several hundred microcap stocks, most of which are reporting domestic or foreign issuers, but a substantial minority of which are non-reporting. The Committees believe that these are reasonable assumptions for the microcap market-making profile of major wholesale market-makers.
In summary, the PWC Study concludes that the average cost per issuer will be in excess of $6000 per review. Notably, the PWC Study also finds a serious flaw in the Commissionís assumption that clerical staff paid $15 an hour could perform 70 per cent of the review. The PWC Study notes that employer-related taxes, health coverage, and other costs to the employer are not factored in. Weighing those costs, a broker-dealer would have to depend on clerical staff making little more than the minimum wage to perform 70 per cent of the review work in order to fall within the SECís cost estimate. The PWC study also notes that the SEC analysis ignores collateral costs to the broker-dealer, such as the need to either postpone or curtail other compliance functions, or to hire and train additional staff.
The Commission notes that "[s]ome broker-dealers may not want to expend the time or the cost to obtain the non-reporting issuer information and may therefore choose not to publish price quotes." The Commission goes on to explain that "[t]his could make it somewhat more difficult for investors to determine what prices other market participants are willing to bid or offer for the security, although they could call a broker-dealer publishing a name-only quotation to obtain a priced quotation." In these words the Commission seems to partially recognize, but discount, the likely impact that the Reproposal would have on liquidity. If a broker-dealer concludes that the Rule's costs are too high with respect to a particular security or group of securities, the broker-dealer may find it more cost-effective not to merely shift from priced quotations to unpriced expressions of interest, but to simply exit entirely from dealing in those securities. Even where a broker-dealer does choose to shift from priced to unpriced quotations, that constitutes an important degradation in market efficiency and price transparency.
Litigation Costs. The Reproposal's discussion of costs entirely overlooks the cost of increased litigation exposure. In particular, the general thrust of the proposal, to combat microcap fraud, combined with the enhanced "red flag" review requirements under the Reproposal are likely to result in plaintiffs' counsel naming broker-dealers as third-party defendants in class action lawsuits. Plaintiffs' counsel can be expected to allege at every available opportunity that market-makers should have recognized red flags concerning an issuer and ceased market-making activity in a security.
Moreover, as the Committees pointed out in their comment letter on the 1998 proposal, the requirement that broker-dealers make available to any requester information that it believes "is accurate and current in all material respects, and . . . is obtained from reliable sources" would lead to new litigation exposure. This concern is very much pertinent to the Reproposal as well, particularly to the statement in the Reproposal's proposed Rule 15c2-11(g)(1) that, with regard to information that is to be provided on request of any "customer or prospective customer"
[b]y providing this information to others under this paragraph . . . you represent that, as of the date recorded under paragraph (b)(3)(iii) of this section, you had a reasonable basis under the circumstances for believing that the information was accurate and current in all material respects and was obtained from reliable sources. . . .
While existing Rule 15c2-11 contains a similar (but somewhat narrower) requirement, other aspects of the Reproposal, such as the heightened red flag review requirement, the elimination of piggy-backing, and the annual update requirement, make it much more likely that claims will be asserted in private civil litigation charging market makers with alleged "misrepresentations" under Rule 15c2-11(g)(1). While the Commissionís above-quoted statement provides a defense to the broker-dealer that its representation and accuracy was only as of the date of its required review, plaintiffs can be expected to try to resist a motion to dismiss by arguing that they are entitled to discovery as to whether the broker-dealer knew or should have known as of the date of its review about the underlying allegations. Even without the cost of discovery, the anticipated cost of litigating a motion to dismiss is an incentive to settle. Rather than face this panoply of costs and legal risks, market-makers are likely to make a business decision to avoid quoting many non-Nasdaq equity securities.
Costs to Investors and Issuers. Because of the significant costs discussed above, participation by legitimate market-makers in many OTC equity securities is likely to decline significantly. This will have a very adverse impact on the liquidity and transparency of these securities, to the great detriment of investors. The Reproposal fails to discuss these costs in any detail. For example, investors in certain categories of securities, such as securities of financially distressed companies, companies emerging from bankruptcy reorganization, or freely traded shares of non-reporting companies, may be particularly disadvantaged. There is no effort made in the Reproposal to discuss the particular impact on these categories of securities, nor even to measure how many investors or issuers might fall into these categories. There is also no discussion of the prospect, which the Committees believe is great, that many of the microcap securities will be even more prone to abuse as a result of this exodus of market-makers. Finally, as mentioned previously, the Reproposal also says almost nothing about the potential increase in the cost of raising capital for small businesses.
The Reproposal's discussion of the purported benefits of the proposed amendments to Rule 15c2-11 is very revealing of the basic misconception that underlies the Commission's entire approach. The Reproposal states:
The publication of quotations by broker-dealers can facilitate the fraudulent promotion of microcap securities. In our view, the reproposal generally would improve the quality of the markets for securities subject to Rule 15c2-11 and would help protect investors in fraudulent schemes involving these securities. . . . In our view, when broker-dealers must review specified issuer information before publishing priced quotations, they are less likely to become unwitting participants in unlawful schemes of unscrupulous broker-dealers or promoters.
This passage reveals a critical false premise on which the Reproposal is anchored. The statement that quotations by broker-dealers can "facilitate" a fraudulent scheme is only true insofar as a market-maker is itself a knowing participant in the scheme (in which case, diligent surveillance and severe enforcement action, rather than regulatory prescriptions that will be flouted, are the appropriate solution). The Committees do not understand how the Commission arrived at its belief that the presence of independent market-makers in a security makes the security more vulnerable to abuse. We believe that the existence of independent market-makers deters, rather than facilitates, fraud. Rather than acting as "unwitting participants in unlawful schemes," such market-makers, by stabilizing disparities in supply and demand, weaken the ability of manipulators to perpetuate their scheme. Moreover, to the extent that manipulation or other abusive practices do occur, independent market-makers provide investors with an escape route from the security other than through the manipulators themselves.
Far from being "unwitting participants in unlawful schemes," the presence of market-makers is at least a partial safeguard against fraud. The notion that "publication of quotations . . . can facilitate the fraudulent promotion of microcap securities" is therefore illogical. The function of market-makers is to manage disparities between supply and demand, rather than to give investment advice, or to serve as information repositories. Heaping new obligations to review issuer information on an ongoing basis will reduce the number of market-makers in OTC securities. Whatever "benefit" that review might yield therefore has to be netted against the detriment to investors of a weaker pricing mechanism that would result from having fewer market-makers available.
We are not alone in questioning the Commission's premise that market making as such inhibits rather than facilitates securities fraud. As one investor explained in response to the 1998 Proposal:
I do not agree, however, with the Commission's view that 'microcap fraud is facilitated by broker-dealers that publish quotations of a security without reviewing any issuer information.' . . . . In fact, it is the broker dealersí very participation in the market making processóso long as they are legitimate actorsóthat encourages skeptical public investors to enter the market with sell or short-sell orders. The willingness of sophisticated, well-informed investors to place sell or short-sell orders thwarts the pump priming mechanism of a fraudulent operator before his scheme gets truly out-of-hand. These skeptical investors, generally speaking, do not rely upon market makersí views of the issuers, but instead do their own homework. They do depend, however, upon the presence of honorable market makers without whose participation even the most sophisticated investors would fall prey to the boiler room trading tactics of the promoters.
Our experience is consistent with this observation Ė investors make investment decisions based on many factors and sources of information, but the presence of market makers in a security is only significant to investorsí decisions insofar as that presence provides some confidence as to liquidity. Investors do not rely on market-makers as a source of information about issuers. Requiring market-makers to review, maintain, and provide on request specified regulatory information is unlikely to provide any benefit to investors. Rather, investors will continue to rely primarily on current business information from the financial media, recommendations from brokers or investment advisers, or their own analysis.
Transformation of the Role of Market-Makers
The Reproposal would require a more fundamental transformation in the nature of market-making than the Commission appears to realize. It would require market-makers to monitor information that no one in the marketplace currently relies upon market-makers to gather. By doing so, it would create a quasi-regulatory function for market-makers that they are ill-equipped to perform.
The information that is of concern to market-makers largely pertains to recent news about the issuer that could affect the short-term supply and demand for the issuer's security, and that therefore should be factored into its quote. This includes information on the amount of stock issued and outstanding, the size of the public float versus restricted shares, and the identity of large positions in the security. It also includes current news indicating whether to expect buy or sell orders from the public or other broker-dealers. A market-maker's time horizon for this analysis ranges from a fraction of the trading day to a few business days. Information in issuers' financial statements is therefore typically much less important to market makers than information that provides a better understanding of near-term profitability and trading flows. Significantly, by setting quotations in reliance on this type of information a market-maker's normal activity is a factor that can undermine attempts to manipulate the price or supply of a security.
The types of information that the Reproposal would require market-makers to initially review and periodically update are for the most part categories of information that market-makers may otherwise have little reason to track. Market-makers would be charged with an obligation to collect information that has little or no bearing on their ability to make markets. While existing Rule 15c2-11 is intended to create a level of quasi-"due diligence" to ensure that initial quotations are not furnished to a quotation medium in the absence of any information about the issuer, it was not intended to be, nor does it function as, a device through which market-makers price their quotations. Once a security begins trading, the emphasis properly shifts to full disclosure by the issuer to the marketplace, so that investors can make informed decisions. The Commission does not cite, and the Committees do not believe there exists, any evidence that investors have any expectation that market-makers, by virtue of making quotations, make any representation about the true value of an investment. By creating this new role for market-makers, the Reproposal fundamentally changes the nature of Rule 15c2-11 and transforms the function of market-makers.
Regulatory Concerns Posed by "Red Flag" Review.
The Reproposal substantially expands the scope of market-maker review from what was contained in the 1998 Proposal by appending a statement titled "Guidance on the Scope of a Broker-Dealerís Review Under Current Rule 15c2-11 and the Amendments." While this appendix is not denominated as a rule, and therefore would not be published in the Code of Federal Regulations, it lays out highly detailed regulatory criteria, characterized by the Commission as "red flags," that would require broker-dealers to expand their reviews of issuer information. The Committees urge that, if the Reproposal is adopted, this appendix should be stricken. If the Commission believes that any of the requirements set out in the appendix are necessary, they should be placed into the Rule itself rather than into a document of uncertain legal status.
The committees have deep concerns with the suggested enhanced review of "red flags" as outlined by the appendix. Our concerns exist on two levels. First, we have general objections to imposing on market-makers an open-ended obligation to investigate beyond the information provided by an issuerís officers, directors, lawyers or accountants. Second, we have specific concerns with a number of the items that the Commission indicates should be "red flags" of possible fraudulent conduct.
As discussed above, the Committees believe that the Commission has significantly underestimated the burdens that the Reproposal would impose on market-makers. The required enhanced review in the presence of "red flags" is a conspicuous example. The Commission states that if a "red flag" exists, "the broker-dealer must inquire further to reasonably determine whether the informationís source is reliable." If the information was obtained from another broker-dealer, the information is to be "substantiated." If the information was from the issuer or some other source, "the broker-dealerís efforts to satisfy itself with respect to the accuracy of the information will vary with the circumstances and may require the broker-dealer to obtain additional information or seek to verify existing information." "If the immediate source of the issuer information is unreliable, however, the broker-dealer should view that source with skepticism and attempt to obtain the Ruleís information from another source." In any event, a broker-dealer should not publish a quote "unless and until those red flags are reasonably addressed." Moreover, the Commissionís enumerated 28 red flags "are not comprehensive, as red flags depend on the facts and circumstances of each case."
Both in their parts and in their whole, these requirements are disturbingly vague. To avoid the risk of after-the-fact second guessing by courts or the Commission, responsible broker-dealers are likely to interpret these open-ended requirements as requiring highly intensive examination. Notwithstanding the Commissionís assurance that "the Ruleís standard of review does not approach the depth of inquiry generally associated with an underwriterís obligations in a registered public offering or with a retail brokerís obligations in recommending a security to a customer," broker-dealers may feel pressured to expend similar efforts to such reviews. The compliance costs in these situations would dwarf the Commissionís cost estimates of $40 per hour and 4-8 hours to conduct a review.
This open-ended enhanced review requirement could also frequently raise nettlesome questions under the insider trading laws. In order for a market-maker to satisfy the enhanced review requirement, it is likely to seek as much detailed follow-up information from issuer management as it can. If successful, that could very well put the market-maker in possession of material non-public information about the issuer. Whether the market-maker could then quote, or would have to abstain, or quote only after disclosing the information to a much greater extent than paragraphs (f) and (g) contemplate, would be very difficult, fact-specific questions that could require advice of counsel. This would be yet another cost that market-makers would have to absorb, but which the Reproposal does not mention.
Another concern is the possibility that the red flag review requirement could open opportunities for short-sellers to conduct a "bear raid." Since the Commission states that the enumerated red flags are not comprehensive, and other items could be red flags depending on the facts or circumstances, market-makers may regard any negative report about an issuer, including unsubstantiated rumors, as a potential red flag, triggering extensive review. This means, at a minimum, that the market-maker will have to suspend quotations until it has satisfied itself that it has complied with the enhanced review requirement. In circumstances where there are few market-makers, this could lead to new abusive tactics by manipulators.
Rather than contend with all of these regulatory uncertainties and compliance costs, a responsible (and fiscally prudent) broker-dealer is likely to simply drop a microcap security when it learns of an item that could be construed as a "red flag." This would be very unfortunate, both for the companies and their investors. Many of the "red flags" cited by the Commission are events that typically occur not only to sham companies, but to legitimate but financially troubled companies Ėe.g, bankruptcy, delisting or disposition of significant assets (item 20). Further losses in liquidity due to the withdrawal of market-makers would further harm the issuer. Obviously the adverse effects on investors would be even greater.
Concerns with Specific Enumerated "Red Flags."
In addition to the overall concerns discussed above, the Committees believe that many of the specific items cited by the Commission, while they may have been associated with wrongdoing in an isolated instance, are typically innocuous events that should not automatically trigger heightened review. For example, we question the need for the following items on the Commissionís list:
Item 13. Unusual auditing issues. Listing "change of accountants" as a red flag is questionable. It is not unusual (and may be helpful in ensuring auditor independence) for companies to change auditors periodically. Neither issuers nor their auditors should be discouraged from doing so out of concern that their action will impact the liquidity of the issuerís securities.
Item 14. Extraordinary items in notes to financial statements, e.g., unusual related party transactions. This is a problematic item if the Commission hopes to keep the cost of reviews anywhere near its estimate of four hours and $40 per hour to satisfy a 15c2-11 review of a reporting issuer. It is difficult to see how a market maker could ever determine whether there are any extraordinary items in financial statement notes relying largely on clerical staff and only one-half day of personnel time. Moreover, there are a great many related party transactions (e.g., mortgage loans or other loans to officers, or rental of real estate from officers or related persons) that are commonplace and innocuous in many legitimate small companies.
Item 16. Broker-dealer receives substantially similar offering documents from different issuers with similar characteristics. Screening for this item could also involve costs that are exponentially higher than the Commissionís estimated costs, since with every review the market-maker would have to cross-review offering documents of all companies that the market-maker receives. In addition, the characteristics listed by the Commission are not necessarily indicative of any wrongdoing For example, the same attorney may be involved with different issuers simply because he or she has built a client base in a particular market sector. Similarly, directors may serve on multiple companies because of their expertise in a line of business.
Item 17. Extraordinary gains in year-to-year operations. This item is extremely vague. "Extraordinary" gains usually are a hallmark of a successful small business, rather than of misconduct.
Item 20. Significant events involving an issuer or its predecessor, or any of its majority owned subsidiaries. Again, this item is very vague. Moreover, the Commission mentions "change in control of the issuer," "merger, acquisition or business combination" or "acquisition or disposition of significant assets" as items that should trigger red-flag review. These events are very common in the life of normal small companies, and in our view are not particularly indicative of possible wrongdoing.
Item 25. "Hot industry" microcap stocks. The Committees do not think that it would be appropriate to make entire industry groups into suspect categories requiring heightened review.
Additional Comments on Specific Aspects of the Reproposal.
In addition to the general concerns with the Reproposal expressed above, the Committees have the following additional suggestions for modifications to the Reproposal.
Continuing Duty to Review. The Commissionís claim that there is no continuing duty to review issuer information "[o]nce the broker-dealer has complied with the Ruleís requirements" may be in conflict with a provision of the proposed amendments. Subparagraph (d)(2) requires that a broker-dealer keep a written record of "any other material information (including adverse information) about the issuer that comes to your knowledge or possession before you publish a quotation." It is unclear if "before you publish a quotation" refers only to initial quotations, or also to the required annual review. If it is the latter, the requirement would likely require compliance personnel to constantly monitor market rumors, news reports, and other incoming information about the issuer that might be deemed within the broker-dealerís "knowledge or possession" to determine if the information is material. This would effectively result in a more or less continual review requirement. To address this, the Committees suggest that if the Commission adopts the proposed amendments, it drop subparagraph (d)(2).
Review of Materials Filed Under Rule 12g3-2(b). Under current Rule 15c2-11, a broker-dealer proposing to publish quotations for securities of a non-reporting foreign private issuer that relies on Rule 12g3-2(b) must review the information furnished to the SEC by the issuer pursuant to that rule. Under the Reproposal, a broker-dealer could not fulfill its responsibilities by relying on review of Rule 12g3-2(b) materials, and instead would have to review the same information as it would with respect to domestic non-reporting issuers, with some allowances made for differences between U.S. and foreign accounting standards and reporting periods. The Committees believe that the obligation to review financial information for non-reporting foreign issuers would be particularly burdensome, especially if market-makers need to familiarize themselves with foreign financial accounting standards. These new burdens will result in U.S. investors having less access to opportunities in foreign securities. We urge the Commission to permit broker-dealers to continue relying on Rule 12g3-2(b) materials for their review. The 12g3-2(b) materials are sufficient for an exemption from reporting under the 1934 Act, and should also be satisfactory for market-making under rule 15c2-11.
Refusal of Issuer to Provide Information. In instances where a non-reporting issuer refuses to provide information to a market-maker about enforcement actions taken against any principal of the issuer, or about events such as changes in control, significant increases in outstanding equity securities, mergers and acquisitions, bankruptcy proceedings or delisting, proposed section (c)(6)(xi)(C) and (c)(6)(xii)(C) would require the market-maker to describe steps taken to obtain that information from the issuer. The Committees believe that the rule should further state that a market-maker has no further obligation to try to discover these categories of information from a non-reporting issuer once it has been spurned by issuer.
We also believe that there are additional categories of information required in the Reproposal that may only be available from a non-reporting issuer. For example, some of the information required under proposed section (c)(6)(v), particularly the total number of securityholders of record for the security, may only be available through the issuer. Likewise, the "business addresses of the executive officers, directors, general partners, promoters, and control persons" of a non-reporting issuer may only be available through the issuer. The Committees believe that in these and other situations where information required by the proposed Rule is only available from the issuer, the market-maker should have no further obligation to try to obtain the information if the issuer refuses to divulge it.
Quotations on Alternative Trading Systems. The Reproposal would define the term "quotation medium" to include priced or unpriced quotations on, inter alia, "an alternative trading system or other device that is used by brokers or dealers to disseminate quotations to others." The Committees believe that this definition is overly broad. It could, for example, force the requirements of 15c2-11 onto a broker-dealer based on an isolated single-sided quotation or expression of interest placed on an alternative trading system or electronic communication network. We recommend that quotations on alternative trading systems or electronic communication networks should be excluded unless they are two-sided orders placed on a system under the broker-dealerís name for at least 5 consecutive business days.
Providing Information on Request. Section (g)(1) of the Reproposal would require a market-maker to make much of the review information "promptly available upon request to any customer, prospective customer, other broker or dealer, or information repository." The Committees believe that the term "potential customer" is far too broad, and essentially provides an obligation to provide the information to anyone who requests it. We do not believe that market-makers should have such a broad obligation toward the entire world, and we recommend striking the words "prospective customer." Moreover, because of the litigation concerns discussed above, we urge the Commission to drop the provision that the act of providing this information to a requester, in and of itself, is an implicit representation as to the market-maker's basis for believing that it is accurate, current, or obtained from reliable sources.
The Proposed Securities Exemptions
The Committees believe that the proposed exemptions from Rule 15c2-11 for non-microcap issuers are a significant improvement over the 1998 Proposal. We strongly agree with the Commission that larger issuers, more liquid securities, and fixed-income debt securities are not prone to the sorts of abuses that trouble some sectors of the microcap markets. Consequently, we urge the Commission, by interpretive release or no-action letter, to exclude these categories of issuers from the requirements of existing Rule 15c2-11.
In addition, we believe that some adjustments to the proposed exclusions are appropriate. We believe that the following changes would help to refine the focus of the rule:
Suggestions for Alternative Approaches to Combating Microcap Fraud.
As explained throughout this letter, the Committees believe that the reproposed amendments to Rule 15c2-11 are not a desirable approach to the scourge of microcap fraud, and would in all likelihood have counterproductive results. We believe that by far the most effective approach to attacking microcap fraud is vigorous law enforcement. We applaud the Commissionís efforts to crack down on abuses in these markets, as well as the efforts of the self-regulatory organizations and other civil and criminal authorities. Other SEC regulatory initiatives, such as recent reforms to Regulations D and S and Form S-8 under the Securities Act of 1933, should also be helpful. We believe that these efforts have gone a long way to reducing the extent of the problem as much as possible.
While we do not believe that the reproposed amendments to Rule 15c2-11 would be a useful supplement to these efforts, we do offer some suggestions for other regulatory approaches that the Commission could consider:
Supplemental Obligations on Dealers. While the Committees do not believe that imposing significant new issuer review requirements on legitimate market-makers is a constructive approach to microcap fraud, it may be appropriate to place heightened supervisory obligations on broker-dealers that derive a significant portion of their revenues from dealer services provided in microcap securities. A precedent for a revenue-based approach exists in the expanded disclosure requirements that the Commission imposed in its Penny Stock Rules on broker-dealers that recommended penny stocks to customers. The Committees would welcome the opportunity to explore this further with the Commission staff.
Expanded Use of Trading Halt Authority. The Commission should encourage the NASD to extend its trading halt authority to include suspicion of manipulation or inaccurate issuer information for non-NASDAQ OTC securities. The Commission should also continue the recent expansion in the SEC's use of trading halts where it sees manipulative activity in a security or incomplete or out-of-date information about an issuer.
Information Repositories. The Commission should encourage the development of one or more information repositories, free and accessible over the Internet, containing information about non-reporting issuers. The Commissionís approach could be based on the repository for information on municipal securities issuers provided under Rule 15c2-12.
Possible Alternative Changes to Rule 15c2-11. Another possible response to microcap fraud would be some modifications to Rule 15c2-11, albeit different ones from the pending proposed amendments. One possibility, which is an element of the Reproposal, is to eliminate "piggy-backing" the review of the first market-maker to initiate priced quotations on microcap equity securities. In our comment letter on the 1998 Proposal, the Committees indicated that we could support this step, although not because we thought it would be a helpful step in deterring fraud, but because it would make the other sweeping changes somewhat less destructive to market liquidity. We do not understand how eliminating piggy-backing, in and of itself, would be a helpful step in combating microcap fraud.
A more constructive measure might be to require that the broker-dealer that conducted the initial review include an indicator in its quotation to inform the marketplace of that fact. This would make it easier for investors and regulators to identify which broker-dealer is responsible for reviewing the issuerís information, without creating regulatory burdens that might reduce the number of market-makers providing liquidity to the security.
An additional constructive change to Rule 15c2-11 would be to excuse market-makers from conducting a 15c2-11 review if all of the categories of information that they would be required to review are available through an information repository. This would be beneficial in at least two respects. First, it would avoid the unnecessary duplication of having multiple parties reviewing and maintaining exactly the same documentation (an especially significant point if piggy-backing is curtailed or eliminated). Second, it would provide an incentive for voluntary industry financial support for such a repository.
Thank you for providing the Committees with the opportunity to comment on the reproposed amendments to Rule 15c2-11 and 17a-4. We hope that the comments offered above will help the Commission in strengthening the integrity of the microcap markets while removing unnecessary regulatory burdens. If we can be of further assistance, please do not hesitate to contact the undersigned, or George R. Kramer of the SIA staff at 202/296-9410.
Lee B. Spencer, Jr., Chairman R. Gerald Baker, Chairman
Federal Regulation Committee Self-Regulation Committee
Cc: The Honorable Arthur Levitt, Chairman
The Honorable Norman S. Johnson, Commissioner;
The Honorable Isaac C. Hunt, Jr., Commissioner;
The Honorable Paul R. Carey, Commissioner;
The Honorable Laura S. Unger, Commissioner;
Annette L. Nazareth, Director, Division of Market Regulation;
Robert L.D. Colby, Deputy Director, Division of Market Regulation;
Catherine McGuire, Associate Director and Chief Counsel, Division of Market Regulation;
James Brigagliano, Assistant Director, Division of Market Regulation;
Florence E. Harmon, Assistant Director, Division of Market Regulation;
Nancy J. Sanow, Senior Special Counsel, Division of Market Regulation.
Irene A. Halpin, Division of Market Regulation;
Chester A. McPherson, Division of Market Regulation;
Jerome J. Roche, Division of Market Regulation;
Elizabeth P. Gray, Assistant Director, Division of Enforcement;
Mary L. Schapiro, President, NASD- Regulation, Inc.