[Federal Register Volume 64, Number 44 (Monday, March 8, 1999)]
[Proposed Rules]
[Pages 11124-11153]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-5299]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
Release No. 34-41110; File No. S7-5-99
RIN 3235-AH40
Publication or Submission of Quotations Without Specified
Information
AGENCY: Securities and Exchange Commission.
ACTION: Reproposed rule.
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SUMMARY: The Securities and Exchange Commission is reproposing for
comment amendments to Rule 15c2-11 under the Securities Exchange Act of
1934 (Exchange Act). Rule 15c2-11 governs the publication of quotations
for securities in a quotation medium other than a national securities
exchange or Nasdaq. Also, we are reproposing a companion amendment to
relocate in Rule 17a-4 under the Exchange Act the record retention
requirement currently contained in Rule 15c2-11. The original proposal
was issued in February 1998 in response to concerns about increased
incidents of fraud and manipulation in over-the-counter (OTC)
securities, which typically involve thinly-traded securities of thinly-
capitalized issuers (i.e., microcap securities).
The reproposed amendments are more limited than the initial
proposal and focus the Rule on those securities the Commission believes
are more likely to be prone to fraud and manipulation. The reproposal
is part of the Commission's continuing efforts in regulatory,
inspections, enforcement, and investor education areas that are key to
deterring microcap fraud.
In addition, the reproposal will increase the information that
broker-dealers must review before publishing quotations for non-
reporting issuers' securities, and will ease the Rule's recordkeeping
requirements when broker-dealers have electronic access to information
about reporting issuers. Finally, we are giving guidance to broker-
dealers on the scope of the review required by the Rule and providing
examples of ``red flags'' that they should look for when reviewing
issuer information.
DATES: Comments must be received on or before April 7, 1999.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,
NW, Mail Stop 6-9, Washington, DC 20549. Comments may also be submitted
[[Page 11125]]
electronically at the following E-mail address: [email protected].
All comment letters should refer to File No. S7-5-99. All comments
received will be available for public inspection and copying in the
Commission's Public Reference Room, 450 Fifth Street, NW, Washington,
DC 20549. Electronically submitted comment letters will be posted on
the Commission's Internet website (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Any of the following attorneys in the
Division of Market Regulation, Securities and Exchange Commission, 450
Fifth Street, NW, Mail Stop 10-1, Washington, DC 20549, at (202) 942-
0772: Nancy J. Sanow, Irene A. Halpin, Florence E. Harmon, Chester A.
McPherson, or Jerome J. Roche.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Executive Summary
A. Overview of the microcap fraud problem and efforts to prevent
further abuses
B. Background of Rule 15c2-11 and recent proposed amendments
II. Overview of Reproposed Amendments
III. Discussion of Amendments
A. Securities excluded from the Rule
1. Securities satisfying a trading value test
2. Securities satisfying a bid price test
3. Securities of issuers satisfying a net tangible assets test
4. Non-convertible debt, non-participatory preferred stock, and
asset-backed securities
5. Other Exceptions
B. Quotations subject to the Rule
1. The initial quotation for a covered OTC security
2. Priced quotations
3. Annual review
C. Information required under the Rule
1. Reporting issuers delinquent in their filings
2. Issuers in bankruptcy
a. Reporting issuers
b. Non-reporting issuers emerging from bankruptcy
3. Non-reporting foreign private issuers
4. Other non-reporting issuers
D. Information available upon request
E. Information repository
F. Definitions
G. Preservation of documents and information
H. Transition and exemptive authority provisions
I. Information submitted to the NASD
IV. General Request For Comments
V. Effects on Efficiency, Competition, and Capital Formation
VI. Costs and Benefits of the Amendments
A. Benefits
B. Costs
VII. Initial Regulatory Flexibility Act
VIII. Paperwork Reduction Act
A. Collection of information under the amendments
B. Proposed use of information
C. Respondents
D. Total annual reporting and recordkeeping burden
1. Burden-hours for broker-dealers
2. Burden-hours for issuers
3. Total burden-hour costs to broker-dealers and issuers
4. Capital cost to broker-dealers and issuers
E. General information about the collection of information
F. Request for comments
IX. Statutory Basis and Text of Proposed Amendments and Rule
Appendix
I. Introduction
II. Quotation Events Triggering the Review Requirement
III. The Review Process
A. Introduction
B. Source reliability
1. Determining whether a source is reliable
2. Examples of unreliable sources
C. Document review obligations
D. Scope of review following a trading suspension
IV. Examples of Red Flags
I. Executive Summary
A. Overview of the Microcap Fraud Problem and Efforts to Prevent
Further Abuses
Because incidents of fraud and manipulation involving microcap
securities are a serious concern, the Commission, along with other
regulators, has made combating microcap fraud one of its top
priorities. Microcap securities generally are characterized by low
share prices and little or no analyst coverage.\1\ The issuers of
microcap securities typically are thinly-capitalized and information
about them often is limited, particularly when they are not subject to
the Commission's periodic disclosure requirements. Securities of
microcap companies usually are quoted on the OTC Bulletin Board
operated by the National Association of Securities Dealers, Inc.
(NASD), or in the Pink Sheets published by the National Quotation
Bureau, Inc. (NQB), but they are not exclusive to these quotation
mediums.\2\
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\1\ The term microcap securities is not defined under the
federal securities laws or regulations. The use of the term
``microcap securities'' in this release, however, should be
distinguished from its use in the mutual fund context. For example,
Lipper Analytical Services, a mutual fund rating organization,
generally categorizes microcap companies as companies with market
capitalization of less than $300 million. Lipper-Directors'
Analytical Data, Investment Objective Key, 2d ed. 1997.
\2\ Microcap securities can also be listed on securities
exchanges or Nasdaq or quoted in alternative trading systems.
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Microcap fraud often involves schemes such as ``pump and dump''
operations, in which unscrupulous brokers sell the securities of less-
seasoned issuers to retail customers by using high pressure sales
tactics and a supply of securities under the firm's control. The
fraudsters create interest in the security by disseminating false or
misleading information about the issuer through, for example, oral
statements, press releases, or the Internet. To further the
manipulative scheme, the retail broker frequently acts as a market
maker in the security or, either on its own or through the issuer's
promoter, induces other firms to act as market makers.
By publishing quotations, the market maker raises the profile of
the security, even though the market maker is not an active participant
in the fraud and publishes quotations solely in response to increased
demand for the security. The broker, promoter, or others orchestrating
the fraud can point to quotations for the security to ``validate'' its
worth. The perpetrators of the fraud then dispose of their stake at an
inflated price. Once they no longer need to stimulate interest in the
security, the market for it collapses and innocent investors are left
holding stock with little or no value.
The defrauded victims of microcap fraud activities are not the only
ones harmed. When other investors become reluctant or unwilling to
invest in the kinds of securities they perceive as prone to fraud,
liquidity for those securities can be impaired. As a result, existing
shareholders can face difficulty in disposing of their holdings and
legitimate issuers of lower-priced stocks can find it hard to raise
capital to start up or expand operations or services. In short,
continuing incidents of microcap fraud are detrimental to the integrity
of our nation's capital markets.
To combat microcap abuses, we have initiated several enforcement,
examination, education, and regulatory measures. These actions include
the following:
In September 1998, we filed 13 enforcement actions against
41 defendants for their involvement in fraudulent microcap schemes that
bilked investors of more than $25 million.\3\
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\3\ For a summary of these cases, see Fight Against Microcap
Fraud ``Paying Dividends'', Press Release No. 98-92 (September 24,
1998), available through our Internet website at <http://
www.sec.gov/news/micronew.htm>.
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We conducted a nationwide sweep to combat fraud through
the Internet, which resulted in 23 enforcement actions against 44 stock
promoters of microcap stocks in October 1998.\4\
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\4\ For a summary of these cases, see Purveyors of Fraudulent
Spam, Online Newsletters, Message Board Postings, and Websites
Caught, Press Release No. 98-117 (October 28, 1998), available
through our Internet website at <http://www.sec.gov/news/
netfraud.htm>.
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[[Page 11126]]
We initiated examination sweeps of several firms that are
active in the microcap market. Our examination staff conducted complex
and resource-intensive reviews of these firms' records for evidence of
the hallmarks of microcap fraud, such as patterns of ``bait and
switch'' sales techniques, misrepresentations and exaggerated claims,
unauthorized trading and refusals to sell securities, market
manipulation, and lax or nonexistent supervision.
We have held numerous investors' town meetings across the
country to educate people about investing wisely, and we have put
together several brochures to assist investors.\5\
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\5\ See, e.g., ``Microcap Stock: A Guide for Investors''
(providing a variety of tips on how to detect and avoid microcap
fraud); ``Cold Calling Alert'' (describing the cold calling rules
and instructing investors how to avoid telephone scams); ``Internet
Fraud'' (describing common frauds including on-line newsletter and
bulletin board posting scams); and ``Ask Questions'' (listing
questions that investors should ask about their investments and
their investment professionals). All of these publications are
available for free from our toll-free publications line at (800)
732-0330 and can be downloaded through our Internet website at
<http://www.sec.gov>.
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We are cooperating with self-regulatory organizations
(SROs) to improve supervision and regulation of the OTC securities
market. For example, we recently approved NASD rule changes that limit
quotations on the OTC Bulletin Board to the securities of issuers that
are current in their reports filed with the Commission or other
regulatory authority.\6\
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\6\ Securities Exchange Act Release No. 40878 (January 4, 1999),
64 FR 1255 (OTC Bulletin Board Release).
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We have taken steps to strengthen our regulations and
close loopholes to help reduce incidents of microcap fraud.
Today, we are taking action on several additional regulatory
measures aimed at preventing further incidents of microcap fraud. In
addition to adopting amendments to Form S-8 \7\ under the Securities
Act of 1933 (Securities Act) \8\ and adopting amendments to Regulation
D,\9\ we are reproposing amendments to Rule 15c2-11 \10\ under the
Securities Exchange Act of 1934 (Exchange Act),\11\ our rule that
governs the quotations by broker-dealers for OTC securities.\12\ Rule
15c2-11 is intended to prevent broker-dealers from becoming involved in
the fraudulent manipulation of OTC securities. However, even if a
broker-dealer technically complies with the Rule's requirements, it
would be subject to liability under other antifraud provisions of the
securities laws, such as Rule 10b-5, if it publishes quotations as part
of a fraudulent or manipulative scheme.\13\
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\7\ Securities Act Release No. 33-7646 (February 19, 1999). The
amendments to Form S-8 restrict the use of Form S-8 for the sale of
securities to consultants and advisors, among other things.
\8\ 15 U.S.C. 77a et seq.
\9\ Securities Act Release No. 33-7644 (February 19, 1999). The
amendments limit the circumstances where freely tradable securities
may be issued in reliance on, and general solicitation is permitted
under, Rule 504 of Regulation D.
\10\ 17 CFR 240.15c2-11.
\11\ 15 U.S.C. 78a et seq.
\12\ In this release, ``OTC stocks'' or OTC securities refers to
securities that are not listed on a national securities exchange or
Nasdaq. ``Covered OTC securities'' refers to those OTC securities
that are subject to Rule 15c2-11. The Rule applies to securities
quoted on the OTC Bulletin Board operated by the NASD, the Pink
Sheets operated by the NQB, and similar quotation mediums. For
further discussion of quotation mediums, see Part III.F. below
\13\ 17 CFR 240.10b-5.
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B. Background of Rule 15c2-11 and Recent Proposed Amendments
Rule 15c2-11 contains requirements that are intended to deter
broker-dealers from initiating or resuming quotations for covered OTC
securities that may facilitate a fraudulent or manipulative scheme. The
Rule currently prohibits a broker-dealer from publishing (or submitting
for publication) a quotation for a covered OTC security in a quotation
medium unless it has obtained and reviewed current information about
the issuer.\14\ The broker-dealer must also have a reasonable basis for
believing that the issuer information, when considered along with any
supplemental information, is accurate and is from a reliable
source.\15\
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\14\ Rule 15c2-11 defines quotation as any bid or offer at a
specified price with respect to a security, or any indication of
interest by a broker or dealer in receiving bids or offers from
others for a security, or any indication by a broker or dealer that
advertises its general interest in buying or selling a particular
security. For the purposes of this release, a ``priced quotation''
is a bid or offer at a specified price.
\15\ See Part III.C. below for a description of the required
issuer and supplemental information.
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The Rule currently contains several exceptions to its prohibitions.
Under the ``piggyback'' exception, the Rule's information requirements
do not apply when a broker-dealer publishes, in an interdealer
quotation system, a quotation for a covered OTC security that was
already the subject of regular and frequent quotations in the same
interdealer quotation system.\16\ A broker-dealer is able to
``piggyback'' on either its own or other broker-dealers' previously
published quotations. This exception assumes that regular and frequent
quotations for a security generally reflect market supply and demand
and are based on independent, informed pricing decisions. However, as a
result of the piggyback provision, the Rule's application is
essentially limited to just the first broker-dealer publishing quotes.
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\16\ An interdealer quotation system is a quotation medium of
general circulation to brokers or dealers which regularly
disseminates quotations of identified brokers or dealers. 17 CFR
240.15c2-11(e)(2). Under the proposed amendments, the definition of
``interdealer quotation system'' would be incorporated into the
definition of ``quotation medium.'' See Part III.F. below for a
discussion of the term ``quotation medium.''
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In February 1998, the Commission published for comment amendments
to the Rule that were designed to curb fraud in microcap
securities.\17\ This proposal would have eliminated the piggyback
provision by requiring all broker-dealers to review current issuer
information before publishing their first quotation for a covered OTC
security, without regard to whether the quotation was priced or
unpriced, and to thereafter review current issuer information annually
if they published priced quotations. With limited exceptions, the
proposal would have applied to any security quoted in a quotation
medium other than a national securities exchange or Nasdaq. The
proposal would also have expanded the information required for issuers
that do not file periodic reports with the Commission (e.g., non-
reporting issuers). In addition, broker-dealers would have been
required to make the issuer information available to anyone who
requested it.
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\17\ Securities Exchange Act Release No. 39670 (February 17,
1998), 63 FR 9661 (Proposing Release).
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In response to the Proposing Release, we received 199 comment
letters from 193 commenters.\18\ The majority of commenters, which
included broker-dealers, issuers, attorneys, and individuals, opposed
many of the proposed changes. Broker-dealers were especially concerned
that they would be exposed to potential liability in civil actions as a
result of their increased review obligations under the proposal.
Commenters also expressed views about the possibility of: reduced
liquidity in covered OTC securities if broker-dealers stopped making
markets; less transparent markets if broker-dealers did not publish
priced quotes to avoid the annual review requirement; less competitive
pricing for covered OTC securities; impaired access to capital by
[[Page 11127]]
issuers; and increased compliance costs for broker-dealers. In
addition, some commenters pointed out that the proposal would not cover
Nasdaq SmallCap securities, which, they noted, have also been the
subject of abusive activities. Some commenters also remarked that the
proposal would not stop microcap fraud, which, in their view, is really
a sales abuse problem.
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\18\ This total includes virtually identical comment letters
from 68 issuers. All comment letters are available in File No. S7-3-
98 at our Public Reference Room, 450 Fifth Street, NW, Washington,
DC 20549. Comment letters that were submitted electronically are
available through our Internet website at <http://www.sec.gov/rules/
s7398.htm>.
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Several commenters, principally state securities regulators and
their national association, supported the proposal. They believed that
microcap fraud would be deterred if broker-dealers are required to
review issuer information and make their own independent and
substantiated determinations before publishing quotations. Further,
commenters favoring the proposal stated that the availability of
information via EDGAR and the speed of communication via the Internet
would ease any increased burden on broker-dealers created by the Rule
amendments. Finally, a number of commenters were more neutral in their
approach and offered views or suggestions on specific provisions.
II. Overview of Reproposed Amendments
The Commission is issuing a revised proposal to amend Rule 15c2-11
to help curtail abuses in the offer, sale and trading of microcap
securities. Because these amendments will significantly change the
Rule's scope, we are publishing them to give interested persons an
opportunity to provide us with their comments and views.
The amendments are intended to have broker-dealers ``stop, look and
listen'' before they begin to quote a covered OTC security in a
quotation medium other than a national securities exchange or Nasdaq.
However, the amendments reflect commenters' concerns about the earlier
proposal by limiting the scope of the Rule principally to priced
quotations and to those securities that the Commission believes are
more likely to be the subject of improper activities. Under these
amendments, the Rule will no longer apply to securities of larger
issuers, or to securities that have a substantial trading price or that
meet a minimum dollar value of average daily trading volume. In
addition, the Rule will only cover priced quotations, except in the
case of the first quotation for a covered OTC security. The provisions
relating to the broker-dealer's obligations under the Rule and the
issuer information that the broker-dealer must review are little
changed from the initial proposal.
We also are providing guidance regarding the steps broker-dealers
should take and ``red flags'' they should consider when reviewing the
Rule's required information. In response to commenters' concerns about
broker-dealer liability, we stress that 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.
In general, the amendments would:
Limit the Rule primarily to priced quotations; \19\
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\19\ The amendments, however, will prohibit the first broker-
dealer from publishing a priced or unpriced quotation for a covered
OTC security unless it complies with the Rule. For a discussion of
the requirements concerning the initial quotation for a covered OTC
security, see Part III.B.1. below.
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Eliminate the Rule's piggyback provision and require all
broker-dealers to review current issuer information before publishing
priced quotations for a security;
Require broker-dealers publishing priced quotations for a
security to review current information about the issuer annually and
upon the occurrence of specified events;
Expand the information required for certain non-reporting
issuers;
Require documentation of the broker-dealer's compliance
with the Rule; and
Require broker-dealers publishing quotes in compliance
with the Rule to provide the issuer information upon request to
customers, prospective customers, information repositories, and other
broker-dealers.
In addition, the amendments would exclude from the Rule's coverage:
Securities with a worldwide average daily trading volume
value of at least $100,000 during each month of the six full calendar
months immediately preceding the date of publication of a quotation,
and convertible securities where the underlying security satisfies this
threshold;
Securities with a bid price of at least $50 per share;
Securities of issuers with net tangible assets in excess
of $10,000,000, as demonstrated by audited financial statements;
Non-convertible debt and non-participatory preferred
stock; and
Asset-backed securities that are rated as investment grade
by at least one nationally recognized statistical rating organization.
These amendments are intended to enhance the integrity of
quotations for securities in this market sector, to improve the quality
of information about smaller, lesser-known issuers, and to foster
greater access to this information by investors. The amendments also
reorganize and simplify the Rule's provisions consistent with the
Commission's Plain English program.
III. Discussion of Amendments
The amendments restructure Rule 15c2-11 by setting forth more
clearly the quotation events that trigger the Rule, the requirements
that the broker-dealer must satisfy, and the nature of the information
that the broker-dealer must review. The amendments state that 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. The Rule will only apply at
specified points in time, namely, when a broker-dealer publishes:
The first quotation for a security;
Its first quotation at a specified price for a security
after another broker or dealer published the first quotation for the
same security;
The first quotation following the termination of a
Commission trading suspension ordered pursuant to section 12(k) of the
Exchange Act \20\ in any security of the issuer of the suspended
security;
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\20\ 15 U.S.C. 781(k).
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A quotation at a specified price for a security after a
period of five or more consecutive business days when it did not
publish any quotations at a specified price for that security;
Its first quotation at a specified price for a security
after the date that is four months after the end of the issuer's fiscal
year, unless the issuer is a foreign private issuer; or
Its first quotation at a specified price for a security of
a foreign private issuer after the date that is seven months after the
end of the issuer's fiscal year.
The broker-dealer's information gathering and review requirements
are substantially the same as the initial proposal.\21\ If the Rule
applies, the broker-dealer must:
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\21\ However, we are narrowing the scope of the requirement
contained in the Proposing Release that broker-dealers provide the
Rule 15c2-11 information to others upon their request. See Part
II.D. below.
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Review the Rule's specified information;
Determine that it has a reasonable basis for believing
that the information is accurate in all material respects and was
obtained from reliable sources;
Record the date it reviewed the specified information, the
sources of the information, and the person at the firm responsible for
the broker-dealer's compliance with the Rule; and
[[Page 11128]]
Preserve the specified information in accordance with Rule
17a-4.\22\
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\22\ 17 CFR 240.17a-4.
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Commenters on the Proposing Release did not object to the standards
set forth in these review and documentation requirements. Rather, they
expressed concerns about the scope of a broker-dealer's review
obligations under the earlier proposal, particularly as some of them
misconstrued the proposal to require continuous updating of
information. To assist broker-dealers publishing quotations for covered
OTC securities, we are giving guidance in an appendix to this release
about the nature of the review we expect broker-dealers to conduct
under both the current Rule and the proposed amendments.
A. Securities Excluded From the Rule
Several commenters suggested that the Rule should cover only those
securities that have the characteristics that have led to abuses in the
microcap market.\23\ These commenters noted that, while the earlier
proposal was intended to focus on microcap abuses, it covered
quotations for a number of non-reporting foreign and domestic issuers'
securities that are unlikely to be the targets of microcap schemes.
They suggested that the amendments be crafted to cover only those
equity securities most likely to be prone to abusive activities.
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\23\ See, e.g., Letter from Securities Industry Association
(April 28, 1998) (SIA Comment Letter).
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We agree that applying the Rule to the securities of larger
issuers, more liquid securities, and certain fixed-income debt
securities is not directly related to microcap fraud concerns.\24\ We
therefore are proposing to exclude from Rule 15c2-11 those securities
satisfying any one of three alternative tests based on: the value of
the security's average daily trading volume (ADTV); the security's bid
price; or the issuer's net tangible assets.\25\ We are also proposing
to exclude debt securities, non-participatory preferred stock, and
investment grade asset-backed securities.
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\24\ Of course the general antifraud provisions of the federal
securities laws, including Rule 10b-5 (17 CFR 240.10b-5), apply to
transactions in all securities, whether or not excluded from Rule
15c2-11.
\25\ We estimate that at least 10% of covered OTC securities
will be excluded from the Rule under these tests. We estimate that
approximately 5% of the OTC securities of U.S. companies, 10% of the
OTC securities of foreign issuers (excluding ADRs), and 66% of OTC
American Depositary Receipts (ADRs) will satisfy any one of these
three alternative tests.
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1. Securities Satisfying a Trading Value Test
To tailor the Rule to transactions that we believe are most likely
to involve microcap fraud, the amendments exclude securities with a
value of worldwide ADTV of at least $100,000 during each month of the
six full calendar months immediately preceding the date of publication
of a quotation.\26\ Convertible securities will also be excluded when
the underlying security satisfies this threshold.
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\26\ We have used an ADTV value of $100,000 in another, but
related, context. Rules 101 and 102 of Regulation M, 17 CFR 242.101
and 102, provide for a one business day restricted period for
securities with an ADTV value of at least $100,000 (as measured over
a 60 day period), if the issuer has a public float value of at least
$25 million. These rules are intended to prevent manipulative
activities during a distribution.
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The majority of OTC stocks of U.S. companies that are not listed on
an exchange or Nasdaq trade infrequently and will not satisfy for a
test based on a value of ADTV of $100,000 or more during each month
over a six month measuring period. However, there are a number of non-
reporting issuers having securities with significant trading levels,
particularly larger foreign issuers with actively traded securities in
their home markets. We think that it is appropriate to take this
trading activity into account in applying the value of ADTV test.
The price of a microcap security that is the subject of a fraud
often is manipulated upward rapidly so that those involved in the
manipulation can quickly sell stock at a significant profit, to the
detriment of innocent investors. Microcap securities involved in such
manipulations often are thinly traded, and the daily trading volume for
such securities rarely reaches a value of $100,000 over an extended
period of time. We believe that measuring the value of the security's
ADTV over a six month period is a way to ensure that the securities
qualifying for this exclusion are not involved in the type of short-
term price manipulations frequently seen in microcap schemes.
A broker-dealer should determine the value of a security's ADTV
from information that is publicly available and that the broker-dealer
has a reasonable basis for believing that the information is
reliable.\27\ In calculating the value of ADTV in U.S. dollars, any
reasonable and verifiable method may be used.\28\ For example, it may
be derived from multiplying the number of shares by the price in each
trade. The NASD may also be able to assist broker-dealers in
determining whether a particular security is eligible for the
exclusion.
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\27\ A broker-dealer will be able to rely on trading volume as
reported by SROs or comparable entities, or any other source
believed to be reliable. Electronic information systems that provide
information regarding securities in markets around the world could
provide an easy means to determine worldwide trading volume in a
particular security. Worldwide trading volume includes all markets,
domestic or foreign, where an OTC security is traded.
\28\ This is comparable to the calculation of value of ADTV
under Regulation M. See Securities Exchange Act Release No. 38067
(December 20, 1996), 62 FR 520, 537.
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Q1. Should the dollar value of ADTV for this exclusion be higher
than $100,000, e.g., $500,000 or $1 million, or should it be a lower
amount, e.g., $50,000? Commenters should provide data and analysis to
support suggested revisions to this proposed threshold.
Q2. Should the dollar value of ADTV measuring period be longer than
six months, e.g., twelve months, or be shorter, e.g., three months?
Should the length of the measuring period depend on the amount of the
value of ADTV threshold, i.e., should a lower value of ADTV threshold
be allowed but require a longer measuring period?
Q3. Should the exclusion based on ADTV value also incorporate a
value of public float test, like Regulation M does? If so, should the
public float value be $25 million or some higher or lower amount? Would
public float information be easy or difficult to obtain for non-
reporting issuers? \29\
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\29\ See id.
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Q4. Rule 101 under the Commission's Regulation M excludes from that
rule's trading prohibitions securities with a value of ADTV of $1
million or more, using a two month measuring period, if the issuer has
a public float value of at least $150 million. Should Rule 15c2-11's
exclusion parallel the terms of this exclusion?
2. Securities Satisfying a Bid Price Test
To limit the Rule to transactions that the Commission believes are
most likely to involve microcap fraud, we are proposing an amendment to
exclude securities with a bid price of at least $50 per share at the
time the quotation is published in the quotation medium.\30\ While the
vast majority of OTC stocks are quoted at lower prices and will not
typically satisfy for a test based on a bid price of at least $50 per
share, there are
[[Page 11129]]
securities of closely-held issuers that are quoted at significant share
prices. The broker-dealer publishing the quotation can use its own bona
fide quotation to satisfy the test. The broker-dealer cannot use its
own or another broker-dealer's unpriced quotation to rely on this test,
even if the broker-dealer publishing a name-only quotation provides a
bid price of at least $50 per share upon inquiry. If a security is a
unit composed of one or more securities, the bid price of the unit,
when divided by the number of shares of the unit that are not warrants,
options, rights, or similar securities, must be at least $50 to be
excepted from the Rule.\31\
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\30\ Most of the Commission's recent trading suspension orders
issued under Section 12(k) of the Exchange Act, 15 U.S.C. 781(k),
have involved securities quoted on the OTC Bulletin Board or the
Pink Sheets. Our staff's analysis of these trading suspension
orders, issued between April 1, 1994 and January 1, 1998, showed
that the suspended OTC securities had an average bid price of
approximately $5, with a median bid price of approximately $3. These
securities had bid prices that ranged from a low of approximately
$0.50 to a high of approximately $18.
\31\ This is comparable to the provisions excluding equity
securities priced at $5 or more from the definition of ``penny
stock'' contained in 17 CFR 240.3a51-1(d)(2).
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Q5. Should this exclusion be based on a bid price higher than $50
per share, e.g., $100 per share or lower, e.g., $20 per share?
Commenters should provide data and analysis to support suggested
alternatives to the proposed threshold.
Q6. Should this exclusion be available only if the security has a
bid price of $50 over a specified period of time?
Q7. Should this test be based instead on the security's last sale
price? If so, should there be a time limit added to such a test so that
a stale last sale price cannot be used?
3. Securities of Issuers Satisfying a Net Tangible Assets Test
Microcap fraud schemes generally involve issuers with limited
assets.\32\ We are therefore proposing to exclude securities of issuers
having net tangible assets in excess of $10,000,000, as determined by
audited financial statements.
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\32\ Analysis of OTC securities that were the subject of recent
Commission-ordered trading suspensions showed the issuers on average
had approximately $3,500,000 in net tangible assets, with a median
of approximately $225,000 is such assets.
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If the issuer is not a foreign private issuer, a broker-dealer
should make this determination using the most recent financial
statements for the issuer that have been audited and reported on by an
independent public accountant in accordance with the provisions of Rule
2-02 of Regulation S-X.\33\ If the issuer is a foreign private issuer,
a broker-dealer should make this determination using the most recent
financial statements for the issuer (dated less than 18 months prior to
the date of the publication of the quotation) that are prepared in
accordance with a comprehensive body of accounting principles, audited
in compliance with requirements of the country of incorporation, and
reported on by an accountant duly registered and in good standing under
the regulations of that jurisdiction.\34\ If audited financial
statements are unavailable, the broker-dealer may not rely on this
exception.
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\33\ 17 CFR 210.2-02.
\34\ These financial statements may be found in filings with the
Commission on Forms 20-F or 6-K, or in submissions under Rule 12g3-
2(b) under the Exchange Act (17 CFR 240.12g3-2(b)), or elsewhere.
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Some commenters suggested that we look to the current definition of
``penny stock'' in assessing the scope of Rule 15c2-11. Exchange Act
Rule 3a51-1 excludes from the definition of penny stock a security of
an issuer having net tangible assets in excess of $2 million, if the
issuer has been in continuous operation for at least 3 years, or $5
million, if the issuer has been in continuous operation for less than
three years.\35\ We preliminarily believe that, for purposes of an
exclusion from the Rule, the net tangible assets amount should be
higher, and, unlike the definition of penny stock, the threshold need
not distinguish between newer and more seasoned issuers.
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\35\ 17 CFR 240.3a51-1.
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Q8. Should the threshold amount for this net tangible assets test
be higher than $10 million, e.g., $20 million? Under what circumstances
would it be appropriate to permit a lower threshold amount? Commenters
should provide data and analysis to support their views on whether the
threshold amount should be raised or lowered.
Q9. For ease of compliance with both Commission and NASD rules,
should this exclusion parallel the exclusion contained in the NASD's
proposed rule that would require broker-dealers to review current
information about the issuer of an OTC security before recommending a
transaction in the security?\36\ The NASD proposal would exclude the
securities of issuers having total assets of at least $100 million and
shareholders' equity of at least $10 million, based on audited
financial statements.
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\36\ See proposed NASD Rule 2315, which the Commission recently
issued for public comment. Securities Exchange Act Release No. 41075
(February 19, 1999). The proposed rule will be available through the
NASD Regulation Internet website at <http://www.nasdr.com> and our
Internet website at <http://www.sec.gov>.
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Q10. Will there be sufficient information in financial statements,
particularly those of non-reporting issuers, to permit broker-dealers
to make the net tangible assets calculation?
Q11. Should the use of financial statements of a foreign private
issuer be limited to financial statements prepared in accordance with
U.S. generally accepted accounting principles (GAAP)?
Q12. Should the use of financial statements of a foreign private
that are not prepared in accordance with U.S. GAAP be limited to
financial statements prepared in accordance with the accounting
standards promulgated by the International Accounting Standards
Committee (IASC)?\37\
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\37\ IASC's accounting standards are summarized on, and may be
ordered through, the IASC's Internet website at <http://
www.iasc.org.uk>.
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Commenters are invited to provide us with their views on the
alternative tests for an exclusion from Rule 15c2-11, as described
above.
Q13. Should all three of the tests based on value of ADTV, bid
price, and net tangible assets be incorporated into Rule 15c2-11?
Q14. Should the proposed exclusions from the Rule be limited to
those securities that satisfy at least two of the three tests?
Q15. Are there other tests that are more appropriate to exclude the
securities of larger, more seasoned issuers from Rule 15c2-11? For
example, should a security that has no or very minimal trading volume
be excluded from the Rule's requirements? What would be an appropriate
low volume threshold? If trading volume suddenly exceeded the low
volume threshold, would broker-dealers publishing quotes find it easy
or difficult to have to obtain and review information before continuing
to publish priced quotations?
4. Non-Convertible Debt, Non-Participatory Preferred Stock, and Asset-
Backed Securities
We are proposing to exclude non-convertible debt securities, non-
participatory preferred stock,\38\ and asset-backed securities that are
rated by at least one nationally recognized statistical rating
organization, as that term is used in Rule 15c3-1 under the Exchange
Act,\39\ in one of its generic rating categories that signifies
investment grade.\40\ Commenters on this
[[Page 11130]]
issue generally supported excluding fixed-income securities from the
Rule.
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\38\ Non-participatory preferred stock means non-convertible
capital stock, the holders of which are entitled to a preference in
payment of dividends and in distribution of assets on liquidation,
dissolution, or winding up of the issuer, but are not entitled to
participate in residual earnings or assets of the issuer. See
paragraph (j)(8) of the Rule proposal, which is based upon a
definition contained in Rule 902(a)(1) of Regulations S (17 CFR
230.902(a)(1)).
\39\ 17 CFR 240.15c3-1 (net capital requirements for broker-
dealers).
\40\ The Commission's staff is engaged in a project to consider
the development of disclosure and registration requirements
specifically related to asset-backed securities. As part of that
project, the staff intends to examine further the role of ratings
with respect to asset-backed securities. Therefore, we consider it
appropriate to limit the proposed exclusion to investment grade
asset-backed securities at this time.
---------------------------------------------------------------------------
The fraud and manipulation that we have observed in the microcap
securities have not been evident in the fixed-income market. In
addition, non-convertible debt securities, non-participatory preferred
stock, and investment grade asset-backed securities generally trade at
prices and in denominations that make them less likely targets for
manipulation. Further, the type of issuer information required by the
Rule is much less relevant to the pricing and trading of these types of
securities.
Q16. Should this exclusion apply to all asset-backed securities or
should the exclusion apply only to asset-backed securities that are
rated investment grade on the basis that those securities are even less
likely to be subject to fraudulent activities?
Q17. Should the Rule exclude all non-convertible debt and non-
participatory preferred stock or should the exclusion apply only to
non-convertible debt and non-participatory preferred stock that are
rated investment grade?
5. Other Exceptions
The exceptions relating to quotations for exchange-listed and
Nasdaq securities, quotations representing a customer's unsolicited
order, and quotations for exempted securities remain substantively the
same as currently in the Rule. As we indicated in the Proposing
Release, the unsolicited status of the customer orders would be called
into question if a broker-dealer repeatedly publishes quotations on the
basis of the unsolicited customer order exception.\41\
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\41\ Proposing Release, 63 FR at 9669. Also, we are combining
into a single provision the current exceptions for exchange-listed
and Nasdaq securities.
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Q18. Should unsolicited customer orders be required to be
identified as such in the quotation medium? Is it feasible for
quotation mediums to show that the quote represents an unsolicited
customer order?
B. Quotations Subject to the Rule
1. The Initial Quotation for a Covered OTC Security
As indicated above, the Rule's requirements will apply at the time
of discrete quotation events. Subject to the Rule's exceptions, the
amendments will prohibit the first broker-dealer from publishing a
priced or unpriced quotation for a covered OTC security in a quotation
medium unless it has obtained and reviewed specified information about
the issuer and the security. Further, this information will need to be
submitted to the NASD, in accordance with the NASD's rules, at least
three business days before the quotation is published.\42\ There is one
situation that ``restarts'' the Rule's requirements: following the
termination of a Commission trading suspension ordered pursuant to
Exchange Act Section 12(k),\43\ the broker-dealer publishing the first
quote, whether it is priced or unpriced, must comply with Rule 15c2-11.
In essence, this is the way the Rule currently works.
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\42\ For a discussion of the requirements under the reproposed
amendments concerning the submission of information to the NASD, see
Part III.I. below.
\43\ 15 U.S.C. 781(k).
---------------------------------------------------------------------------
We believe that the Rule should cover the first quotation as a
means to assure that there is basic information about the issuer
available to the marketplace before trading in the security begins and
to alert regulators that trading in the security will be starting. The
NASD uses Rule 15c2-11 submissions for surveillance and enforcement
purposes and routinely provides copies of this information to the
Commission.
2. Priced Quotations
While the first broker-dealer must obtain the required information
for the initial quotation (priced or unpriced) for a covered OTC
security as discussed above, thereafter the Rule will only apply to
broker-dealers submitting their first priced quotations. The Rule's
review requirements are also triggered when a broker-dealer first
publishes a priced quotation following the lapse of five or more
business days of its priced quotations for the security. In addition,
as discussed below, a broker-dealer must satisfy the Rule's
requirements if it publishes a priced quotation as of a specific date
following the end of the issuer's fiscal year.
We propose to focus the Rule's requirements after publication of
the first quote on priced quotations, because recent microcap
manipulation schemes have primarily involved priced quotations. In
addition, priced quotes are used as indicia of value for a variety of
purposes (e.g., bank loans or pledges of securities). This revision
also responds to the concerns of several commenters that the earlier
proposal could have resulted in some broker-dealers being precluded
from publishing any quotations if they could not obtain the Rule's
required information. We solicit commenters' views, however, on whether
unpriced indications of interest will be used more often in unlawful
microcap activities, and, if so, whether the Rule should cover all
initial quotations.
3. Annual Review
The amendments require a broker-dealer to review the specified
information annually if the broker-dealer publishes priced quotations
for the security. The date by which the annual review must be performed
depends on whether the issuer is a domestic or a foreign company:
Domestic Issuers: The annual review must occur prior to
the first priced quotation that is more than four months after the end
of the issuer's fiscal year.
Foreign Private Issuers: The annual review must occur
prior to the first priced quotation that is more than seven months
following the end of the issuer's fiscal year.
The purpose of this requirement is to make sure that the broker-
dealer periodically reviews fundamental information about the issuer if
the broker-dealer continues to publish priced quotations. The broker-
dealer should know if no current information about the issuer exists or
if current information reflects a significant change in the issuer's
ownership, operations, or financial condition.
While we originally proposed two alternative dates for conducting
the annual review, to simplify the Rule we are reproposing only one
date for each type of security.\44\ Four months after the end of the
issuer's fiscal year, a broker-dealer publishing priced quotes for a
covered OTC security of a domestic issuer must have conducted the
annual review. In the case of a foreign private issuer's security, the
annual review must occur before the broker-dealer publishes a priced
quote following the date that is seven months after the issuer's fiscal
year end. We believe that these time periods give a broker-dealer
sufficient time to obtain and review updated issuer information for
both reporting and non-reporting issuers.
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\44\ The initial proposal would have permitted a broker-dealer
to conduct the annual review as of the anniversary date of the
initial quotation.
---------------------------------------------------------------------------
Some commenters opposed the annual review requirement because of
potential recordkeeping burdens, the perceived difficulty of obtaining
the required information, and the loss of liquidity that could
potentially occur if broker-dealers could not publish priced quotes
because current issuer information was unavailable.\45\
[[Page 11131]]
Commenters stated that the Rule's review requirements represented a
shift from the Commission and the SROs to broker-dealers of the burdens
of overseeing issuer compliance with regulatory requirements.\46\ Some
commenters wrote that the annual review is only appropriate for certain
non-reporting companies or issuers for which only limited information
is available. Other commenters stated that the annual review should not
apply to issuers that are current in their reporting requirements
because this information is available on EDGAR.\47\ A number of
commenters, however, generally supported some sort of required annual
review for broker-dealers publishing priced quotations, although they
differed as to the securities that should be subject to this
provision.\48\
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\45\ See Letter from A.G. Edwards & Sons, Inc., (April 27, 1998)
(A.G. Edwards Comment Letter); and Letter from National Quotation
Bureau, LLC, (April 27, 1998) (NQB Comment Letter).
\46\ See, e.g., A.G. Edwards Comment Letter.
\47\ See, e.g., NQB Comment Letter.
\48\ See Letter from NASD Regulation, Inc., (July 17, 1998)
(NASD Comment Letter); Letter from North American Securities
Administrators Association, Inc., (April 27, 1998) (NASAA Comment
Letter); and SIA Comment Letter.
---------------------------------------------------------------------------
The amendments will apply the annual review requirement to priced
quotations for both reporting and non-reporting issuers' securities. We
believe that an annual review requirement for both reporting and non-
reporting issuers' securities fulfills the objectives of the Rule
without imposing significant burdens on broker-dealers. This is
especially so because we are revising the Rule to cover only those
securities that, in our view, are most likely to be the subject of
microcap fraud schemes and are also limiting the scope of the annual
review to priced quotations. We also note that because information
about reporting issuers is available on the Commission's website, the
review of information about these issuers can be accomplished quite
easily.
Commenters are requested to provide us with their views on the
reproposal's focus on priced quotations.
Q19. Should the Rule cover all broker-dealers' initial quotations,
whether priced or unpriced, as the earlier proposal would have? Will
the reproposal cause broker-dealers to publish unpriced quotes to avoid
complying with the Rule?
Q20. Should the Rule apply exclusively to priced quotes, i.e., the
Rule would not cover any unpriced quotes?
Q21. Are there other approaches that would be more appropriate,
e.g., to cover any initial quote for a covered OTC security by a
broker-dealer, whether priced or unpriced, but not to apply the Rule or
at least the annual review requirement to reporting issuers'
securities? How would such a proposal help reduce instances of microcap
fraud?
Q22. Is the Rule text sufficiently clear in identifying the
quotation events that are subject to the Rule's provisions? Are there
other quotation events that should be covered by the Rule?
Q23. Should the provision pertaining to a lapse in quotations of
five consecutive business days or more provide for a longer time
period, e.g., ten consecutive business days without a priced quotation,
or a shorter time period, e.g., three consecutive business days without
a priced quotation?
Q24. Should the Rule give broker-dealers the option to conduct the
annual review as of the anniversary date of the initial quotation by
the broker-dealer?
C. Information Required Under the Rule
The amendments are substantially identical to the earlier proposal
with respect to the issuer information that a broker-dealer must review
before publishing a quotation for a covered OTC security. Under the
reproposal, a broker-dealer subject to the Rule must gather, review,
and maintain in its records the following issuer information:
For an issuer that has conducted a recent public offering
either registered under the Securities Act of 1933 (Securities Act) or
effected pursuant to Regulation A under the Securities Act, a copy of
the prospectus or offering circular;
For an issuer that files reports with the Commission
pursuant to Sections 13 or 15(d) of the Exchange Act\49\ (reporting
issuer), the issuer's most recent annual or semi-annual report and any
subsequent quarterly and current reports;
---------------------------------------------------------------------------
\49\ 15 U.S.C. 78m and 78o(d).
---------------------------------------------------------------------------
For an issuer that is an insurance company of the kind
specified in Section 12(g)(2)(G) of the Exchange Act,\50\ the issuer's
most recent annual statement referred to in Section 12(g)(2)(G)(i);
---------------------------------------------------------------------------
\50\ 15 U.S.C. 78l(g)(2)(G).
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For an issuer that is not required to file reports
pursuant to Sections 13 or 15(d) of the Exchange Act and that is a bank
or savings association, the issuer's most recent annual report and any
subsequent reports filed with its appropriate federal or state banking
authority; and
For any other issuer, the information, including certain
financial information, specified in proposed paragraph (c)(6) of the
Rule, which must be reasonably current in relation to the day a
quotation is submitted.
The broker-dealer also must obtain and review the supplemental
information contained in paragraph (d) of the reproposed Rule. A
broker-dealer must review a copy of any trading suspension order issued
under Section 12(k) for any of the issuer's securities during the 12
months preceding the publication of the quotation, as well as any other
material information, including adverse information, that comes to the
broker-dealer's knowledge or possession before publication of the
quotation. A broker-dealer must consider this supplemental information,
along with the issuer information, when it determines whether it has a
reasonable basis for believing that the issuer information is accurate
and from reliable sources. While we are not including a requirement
that the broker-dealer obtain and review any trading suspension for a
foreign security that was issued by a foreign financial regulatory
authority, this information must be taken into account by the broker-
dealer if it comes to the broker-dealer's knowledge or possession at
the time that a review is required.
In addition, the broker-dealer must make a record of the
significant relationship information contained in paragraph (e) of the
reproposed Rule, which is unchanged from the Proposing Release. Under
this provision, a broker-dealer would have to document specified
information such as whether the broker-dealer has any affiliation with
the issuer or arrangements to receive any consideration to publish the
quote, and whether the quote is being published on behalf of another
broker-dealer or the issuer, any of its insiders, or any large
shareholder.
Commenters generally did not object to the issuer, significant
relationship, and supplemental information requirements; in fact, some
commenters favored the enhanced information requirements for non-
reporting issuers.\51\ Therefore, we are reproposing these requirements
without any substantive changes, other than revisions relating to
financial statements for non-reporting issuers, as discussed
[[Page 11132]]
below in Part III.C.4. We are addressing below specific points that a
few commenters raised about the information requirements and other
provisions. Commenters are welcome to provide their views on the
information requirements for the various categories of issuers and
should consult the Proposing Release for a more detailed description of
these provisions.\52\
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\51\ In response to the 78 comment letters that we received from
issuers of securities quoted on the OTC Bulletin Board who were
concerned about continued liquidity for their securities, we note
that 33 of these issuers are reporting companies. Also, under
recently approved amendments to NASD Rules 6530 and 6540, all of
these issuers ultimately will need to be reporting companies current
in their reporting obligations in order for their securities to
remain on the OTC Bulletin Board. See note 6 above and accompanying
text. There should be no burdens on reporting issuers to provide
information to broker-dealers wishing to publish quotations because
the issuer information should be available on EDGAR, as long as the
issuers are current in their reporting obligations.
\52\ See Part II.A.4. of the Proposing Release at 63 FR 9661,
9664-9669.
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1. Reporting Issuers Delinquent in Their Filings
In the case of an issuer delinquent in its reporting obligations, a
broker-dealer will not be able to publish an initial priced quotation,
or continue to publish priced quotations after the annual review date,
because it will not be able to obtain the specified reports. A few
commenters indicated concern about the possible adverse implications
for the market for delinquent issuers' securities if broker-dealers
could not publish quotes when current issuer information was
unavailable.\53\ As noted above, we are revising the Rule to permit
broker-dealers to publish unpriced quotations, even in the absence of
current issuer information (except in the case of the first quotation
for the security).
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\53\ See, e.g., NASAA Comment Letter.
---------------------------------------------------------------------------
2. Issuers in Bankruptcy
a. Reporting Issuers
A few commenters urged us to permit broker-dealers to continue to
quote the securities of reporting issuers that had filed for
reorganization under federal bankruptcy law because it would provide
liquidity for these securities.\54\ They noted that it was often
burdensome for small companies that had filed for reorganization under
Chapter 11 of the Bankruptcy Code \55\ to produce audited financial
statements to comply with Exchange Act reporting requirements.
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\54\ See, e.g., Letter from Daniel J. Demers (March 27, 1998)
(Demers Comment Letter); Letter from Robotti & Company, Inc., (April
27, 1998) (Robotti Comment Letter); and NQB Comment Letter. In 1989,
we sought comment on whether there were situations, such as
bankruptcy, that should be addressed if the piggyback provision were
revised. See Securities Exchange Act Release No. 27247 (September
14, 1989), 54 FR 39194 (1989 Release). Commenters on the 1989
Release argued that it was appropriate to permit broker-dealers to
continue quoting the securities of issuers that had filed for
bankruptcy because it provided liquidity for these securities and
suggested that issuers in bankruptcy be identified in the quotation
system by using a special indicator.
\55\ 11 U.S.C. 1101 et seq.
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Commenters suggested that broker-dealers could satisfy the Rule's
requirements by reviewing bankruptcy court filings made by an issuer in
Chapter 11 reorganization when current Exchange Act reports were
unavailable. One commenter also suggested that the Commission permit
delinquent reporting companies that experience a 51% ownership change
as a result of a confirmed plan of reorganization to begin reporting
from the effective date of the reorganization plan with a filing with
the Commission, attaching the court-approved disclosure statement
together with a certified audited balance sheet as of the effective
date.\56\
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\56\ Demers Comment Letter; see also 11 U.S.C. 1125. The
disclosure statement includes, among other things, a description of
the issuer's business plan, a description of any securities to be
issued, and financial information.
---------------------------------------------------------------------------
The reproposal will require a broker-dealer publishing quotations
for a reporting issuer's securities to obtain the issuer's Exchange Act
reports, even if the reporting issuer has filed for Chapter 11
reorganization. Thus, if a reporting issuer that has filed for Chapter
11 reorganization becomes delinquent in its reporting obligations, a
broker-dealer will not be able to publish priced quotations covered by
the Rule. For example, a broker-dealer could not continue to publish
priced quotations as of the annual review date for a covered security
of a reporting debtor that has become delinquent in its reporting
obligations.\57\
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\57\ Broker-dealers would be able to continue to publish
unpriced quotations.
---------------------------------------------------------------------------
The bankruptcy court filings for an issuer undergoing
reorganization under Chapter 11 are not adequate to satisfy the Rule's
requirements. These Rule 2015 bankruptcy reports ordinarily contain
only data about issuer receipts and disbursements and not the type of
issuer financial information contemplated by Rule 15c2-11.\58\ In some
cases, our Division of Corporation Finance may grant issuers in
bankruptcy no-action relief with respect to Exchange Act filing
requirements.\59\ These no-action positions, however, are predicated on
little or no trading occurring in the debtor's securities. The Rule
2015 bankruptcy reports that the Division of Corporation Finance
accepts under its no-action position do not satisfy Rule 15c2-11
because this financial report usually contains only information about
issuer receipts and disbursements. Where a reporting issuer receives
this type of no-action position, a broker-dealer would not be able to
obtain the issuer information required by the Rule until the debtor's
reorganization plan becomes effective, and the debtor files a Form 8-K,
which instead of attaching the Rule 2015 bankruptcy reports, now
includes the issuer's audited balance sheet. Under Rule 15c2-11,
broker-dealers could review this 8-K, which contains an issuer's
audited balance sheet, and then publish priced quotations. From then
on, the issuer must file its Exchange Act periodic reports for all
periods that begin after the plan becomes effective.\60\ The
publication of quotations by a broker-dealer indicates that a market
exists for the issuer's securities. It would be inconsistent with the
premise of the no-action position (i.e., that there is no trading in
the issuer's securities) if a broker-dealer were able to stimulate
trading by publishing quotations without having the issuer's Exchange
Act reports.
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\58\ See Federal Rule of Bankruptcy Procedure 2015 (Rule 2015
bankruptcy reports).
\59\ See Staff Legal Bulletin No. 2 (April 15, 1997) (CF) (Staff
Legal Bulletin No. 2), which is available through our Internet
website at <http://www.sec.gov/rules/othern/slbcf2.txt>. Under Staff
Legal Bulletin No. 2, our Division of Corporation Finance has
granted no-action relief permitting an issuer in Chapter 11
reorganization to satisfy its Exchange Act reporting obligations by
filing the Rule 2015 bankruptcy reports on Exchange Act Form 8-K.
See 17 CFR 249.308. Under Staff Legal Bulletin No. 2, the staff has
allowed a company to substitute its Rule 2015 bankruptcy reports for
its Exchange Act periodic reports when there is little or no trading
in the debtor's securities.
\60\ See Staff Legal Bulletin No. 2.
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Q25. Are there circumstances in which a broker-dealer should be
permitted to publish priced quotations for the securities of delinquent
reporting issuers in bankruptcy? Please describe these circumstances.
Should the Rule prohibit broker-dealers from publishing unpriced quotes
for the securities of these issuers?
b. Non-Reporting Issuers Emerging From Bankruptcy
The Proposing Release contained amendments to permit broker-dealers
that quote the securities of non-reporting companies emerging from
bankruptcy to review the bankruptcy court-approved disclosure statement
and issuer financial information required by the Rule from the date
that the bankruptcy court confirms the reorganization plan.\61\ The
commenters who addressed this issue supported the proposal to limit a
broker-dealer's review to the post-reorganization information.\62\ The
amendments are unchanged from the original proposal.
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\61\ See 11 U.S.C. 1125. The disclosure statement includes,
among other things, a description of the issuer's business plan, a
description of any securities to be issued, and financial
information.
\62\ See Letter from Florida Division of Securities (April 27,
1998) (Florida Comment Letter); NQB Comment Letter; Demers Comment
Letter; and Robotti Comment Letter. Mr. Demers suggested that the
required financial information for non-reporting issuers emerging
from bankruptcy be from the ``effective date'' of the plan, instead
of the ``confirmation date'' of the plan. We are retaining this
amendment from the confirmation date because adequate information is
available about the non-reporting issuer at this point for Rule
15c2-11 purposes.
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[[Page 11133]]
3. Non-Reporting Foreign Private Issuers
In the case of a foreign private issuer that relies on an exemption
from registration under Section 12(g) \63\ of the Exchange Act by
complying with Exchange Act Rule 12g3-2(b), Rule 15c2-11 specifies that
a broker-dealer must review the information submitted to the Commission
under Rule 12g3-2(b).\64\ To qualify for the registration exemption,
the issuer must furnish to the Commission information that the issuer
has made or is required to make public under the law of the country in
which the foreign private issuer is domiciled or incorporated; has
filed or is required to file with a stock exchange on which the
securities are traded and which the exchange has made public; or has
distributed or is required to distribute to its securityholders. For
foreign private issuers that do not furnish the Commission with
information under Rule 12g3-2(b), the Rule currently requires broker-
dealers to obtain and review the same kind of information, including
financial information, as required for non-reporting domestic issuers.
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\63\ 15 U.S.C. 78l(g).
\64\ 17 CFR Sec. 240.12g3-2(b).
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We note that Rule 12g3-2(b) contains no specific requirements
governing the categories of information the issuer must furnish to the
Commission under the exemption. As a result, there is no assurance that
broker-dealers publishing quotes will obtain the same type of
information for each foreign private issuer that claims the Rule 12g3-
2(b) exemption as they must for other non-reporting foreign private
issuers. This can be problematic since a number of issuers claiming the
Rule 12g3-2(b) exemption are foreign microcap companies that can
potentially be subject to the same kinds of abusive practices as their
U.S. counterparts.
Therefore, we are proposing to change Rule 15c2-11 requirements
with respect to quotations for the securities of foreign issuers
complying with Rule 12g3-2(b). Broker-dealers publishing quotations for
the securities of Rule 12g3-2(b) issuers will have to obtain and review
the information specified in paragraph (c)(6) of the reproposed
Rule.\65\ However, as described in more detail below, we propose to
revise the financial statements that must be reviewed for non-reporting
foreign private issuers to recognize the foreign status of these
issuers.\66\ By eliminating the provision for Rule 12g3-2(b) issuers,
all non-reporting foreign private issuers will be treated similarly
under Rule 15c2-11.
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\65\ Some of the paragraph (c)(6) information that broker-
dealers will have to obtain and review may be present in the foreign
issuer's Rule 12g3-2(b) materials.
\66\ See Part III.C.4. below.
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Commenters were divided on whether we should amend the provisions
of the Rule governing the review of information for non-reporting
foreign private issuers.\67\ Because the reproposal excludes the
securities of many larger foreign issuers from Rule 15c2-11 and also
distinguishes between U.S. and foreign accounting standards for those
foreign issuers that continue to be covered, many of the reasons for
permitting broker-dealers to rely on Rule 12g3-2(b) information have
been addressed.
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\67\ For example, some commenters stated that we should delete
the reference to Rule 12g3-2(b) and require broker-dealers to review
the same information as required for all other foreign non-reporting
issuers whose securities are subject to Rule 15c2-11. See, e.g.,
Florida Comment Letter. Other commenters, however, indicated that we
should continue to require broker-dealers to review only the home
country information that certain foreign issuers submit to the
Commission under Rule 12g3-2(b). See, e.g., SIA Comment Letter.
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Q26. Should broker-dealers be required to obtain and review the
same type of issuer information with respect to non-reporting foreign
private issuers providing information under Rule 12g3-2(b) as they must
for other non-reporting foreign issuers? Are there reasons to retain a
special provision in Rule 15c2-11 for foreign issuers furnishing
information under Rule 12g3-2(b)?
Q27. What is the experience of broker-dealers under the Rule when
the foreign issuer has not furnished information to the Commission
under Rule 12g3-2(b)? How difficult or easy will it be for broker-
dealers to obtain the paragraph (c)(6) information for a non-reporting
foreign private issuer?
4. Other Non-Reporting Issuers
The amendments parallel the Proposing Release in their treatment of
non-reporting issuers (i.e., those non-reporting issuers that are not
financial institutions covered by paragraph (c)(4)), except for the new
exclusions discussed in Part III.A. above and the revisions to the
required financial information for non-reporting issuers. As in the
Proposing Release, the Rule will require broker-dealers to review more
information than currently required about the issuer's outstanding
securities; the issuer's insiders, including their disciplinary
history; and certain significant events involving the issuer, among
other items. This information will provide a broker-dealer that is
considering whether to publish quotations for such an issuer greater
understanding of the issuer's operations and a better indication of
whether potential or actual fraud or manipulation may be present.
Several commenters supported the requirement for a broker-dealer to
review the disciplinary information about the insiders of non-reporting
issuers. One commenter believed that if broker-dealers are allowed to
publish quotations without obtaining this disciplinary information, it
would create a loophole for issuers to avoid disclosing information
that would be of utmost importance and would thereby defeat the goal of
the Commission.\68\ While no commenters directly opposed the
requirement to obtain disciplinary information, several commenters
objected to the enhanced information requirements in general as too
difficult and burdensome, especially when issuers are unwilling to
volunteer information.\69\
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\68\ See NASAA Comment Letter.
\69\ See, e.g., Letter from David B. Schneider (April 21, 1998).
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Q28. Should the Rule require the disciplinary history information
for the insiders of all issuers of covered OTC securities, and not just
insiders of non-reporting issuers, on the basis that microcap fraud can
involve issuers whose insiders have histories of prior misconduct?
We are proposing to amend the financial information that a broker-
dealer must review when publishing quotations of both domestic and
foreign non-reporting issuers. The reproposal lists the financial
statements required for a domestic issuer, which must be prepared in
accordance with U.S. GAAP, and sets forth when these financial
statements will be presumed ``current'' under the Rule. Absent contrary
information, a domestic issuer's balance sheet will be considered
current if it is as of a date that is less than 15 months before the
quotation is published, rather than less than16 months as now specified
in the Rule.\70\ This revision comports with existing Exchange Act
requirements regarding when a domestic reporting issuer's financial
statements are considered
[[Page 11134]]
current. The reproposal also will require broker-dealers to review the
specified financial information for such part of the two preceding
fiscal years (in the case of the balance sheet, the preceding fiscal
year) that the issuer (or any predecessor) has been in existence.
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\70\ This provision is a presumption that financial information
that is less than 15 months old is current. However, if the broker-
dealer has other information that indicates that the issuer's
financial condition has materially changed from that shown in the
financial statements, this presumption may not apply, and the
broker-dealer should determine whether more recent financial
information is available. Financial information older than 15 months
is not current and does not satisfy the Rule's requirements. The
presumption for non-financial information is that this information
is considered current if it is as of a date within 12 months of
publication of the quotation.
---------------------------------------------------------------------------
The reproposal also will revise the requirements with respect to
the financial statements that broker-dealers must review when
publishing a quotation for a non-reporting foreign private issuer's
security. The reproposal lists the financial statements that the
broker-dealer must review, which must be prepared in accordance with a
comprehensive body of accounting principles, and sets forth when these
financial statements will be considered current under the Rule. For a
non-reporting foreign private issuer, its balance sheet will be
presumed current if it is as of a date less than 18 months before the
quotation is published.\71\ Also, if the balance sheet is as of a date
more than 9 months before the quotation is published, the broker-dealer
must obtain more current financial information only to the extent that
the issuer has prepared it. The broker-dealer must obtain the specified
financial information for the two preceding fiscal years (one year with
respect to the balance sheet) that the issuer has been in existence.
---------------------------------------------------------------------------
\71\ This presumption will operate in the same manner as for
domestic issuers. See footnote 70 above.
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Q29. Are the financial statement requirements, including the
presumption regarding when the information is considered current, clear
and capable of being complied with by broker-dealers publishing
quotations? Should there be longer time periods for the presumption
regarding when the financial statements for a non-reporting foreign
private issuer are considered current? If so, what time periods would
be appropriate?
Q30. Are there any information requirements for non-reporting
issuers that should be added or removed from reproposed paragraph
(c)(6)?
D. Information Available Upon Request
We believe that some microcap frauds could be prevented if there
were greater investor access to information about those securities and
their issuers. Accordingly, we are reproposing, with some revisions,
the requirement that a broker-dealer publishing quotations for any
covered OTC security make the information promptly available upon
request. In response to the Proposing Release, several commenters
suggested that we restrict the types of persons and entities to which a
broker-dealer must provide the information.\72\ The amendments require
a broker-dealer to provide information upon request to any current
customer, prospective customer, information repository, or other
broker-dealer.
---------------------------------------------------------------------------
\72\ See, e.g., Letter from Security Traders Association (April
28, 1998) (STA Comment Letter). We originally proposed that the
information be made available to anyone upon request.
---------------------------------------------------------------------------
A few commenters asserted that broker-dealers should not be
required to provide information that already is generally available to
the public from other sources (e.g., information for reporting
companies that is available on EDGAR).\73\ We are addressing these
concerns in the amendments by requiring broker-dealers to provide the
required information that is not accessible through EDGAR, any other
federal or state electronic information system, or an information
repository. Further, most commenters responding to this issue were
concerned about the cost of providing information to others upon
request.\74\ We believe that the cost of requiring broker-dealers to
make the information available (including to other broker-dealers) upon
request is minimal.\75\
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\73\ See e.g., Letter from Richard P. Ryder, Esq. (May 12,
1998).
\74\ See e.g., Letter from The Bond Market Association Comment
Letter (April 27, 1998); NQB Comment Letter; and Florida Comment
Letter.
\75\ A broker-dealer may charge for the reasonable expenses it
incurs in producing and forwarding copies of the Rule 15c2-11
information.
---------------------------------------------------------------------------
The amendments retain in substantial form the clause that providing
information to others does not constitute a representation by the
broker-dealer that the information is accurate. Rather, providing the
information to others constitutes a representation that the information
is current in relation to the date the information was reviewed, and
that the broker-dealer has a reasonable basis for believing that the
information was accurate as of the date recorded and was obtained from
reliable sources.
Q31. Should we require broker-dealers to make the information
available to anyone who requests it, particularly if broker-dealers are
permitted to charge reasonable fees? Should broker-dealers be required
to provide information to fewer classes of persons?
E. Information Repository
The amendments, as in the Proposing Release, eliminate the
piggyback provision of the Rule. The elimination of the piggyback
provision and the potential for increased costs of compliance suggest
the desirability of having a data base of information about the non-
reporting issuers of covered OTC securities.\76\ Such a data base also
would enhance the availability of information about little-known
issuers to investors, other professionals, and regulators. The
consensus among the commenters who specifically addressed this issue
was that the creation of a repository would foster access to
information about issuers that do not participate in the public
disclosure system.\77\ For these reasons, we encourage the development
of one or more repositories of Rule 15c2-11 information, but we note
that the existence of a repository will not be necessary for broker-
dealers to comply with the Rule.
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\76\ We note that, for reporting issuers, information
repositories already exist. Broker-dealers are able to access and
review the required information on our EDGAR system, available
through our Internet website at <http://www.sec.gov>. In addition,
broker-dealers may consult federal or state electronic information
systems for information about issuers of covered OTC securities.
\77\ See e.g., Letter from Singer Frumento Sichenzia, LLP,
(April 13, 1998).
---------------------------------------------------------------------------
The amendments establish that the Commission may, upon written
application, designate an entity as an information repository.\78\ In
determining whether to grant or deny such a designation, the Commission
will consider whether an entity:
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\78\ This authority will be delegated to the Director of the
Commission's Division of Market Regulation. We propose to amend Rule
200.30-3, which provides for delegation of authority to the
Director, to include the designation of information repositories.
See 17 CFR 200.30-3.
---------------------------------------------------------------------------
Collects information about a substantial segment of
issuers of securities subject to the Rule;
Maintains current and accurate information about such
issuers;
Has effective acquisition, retrieval, and dissemination
systems;
Places no inappropriate limits on the issuers from or
about which it will accept or request information;
Provides access to the documents deposited with it to
anyone willing and able to pay the applicable fees; and
Charges reasonable fees.
In general, the Commission will consider whether an entity wishing
to act as an information repository is so organized and has the
capacity to be able reasonably to obtain and provide to others current
information required by the Rule. An information repository will be
required to notify the Commission of any material changes in the facts
and circumstances of their application for designation as an
information repository. In the event that an information repository no
longer satisfies these attributes, we may withdraw such designation.
[[Page 11135]]
Some commenters suggested that the Commission assume the task of
serving as the Rule 15c2-11 information repository.\79\ Because the
issuers that would be the focus of any information repository generally
would not be required to file periodic reports with the Commission,
this is not a function that we can assume at this time. The NASD has
also advised us preliminarily that it is unable to undertake the
responsibility of serving as an information repository at the present
time. Therefore, we encourage private sector initiatives for the
creation of one or more Rule 15c2-11 information repositories.
---------------------------------------------------------------------------
\79\ See, e.g., STA Comment Letter.
---------------------------------------------------------------------------
Q32. Are there other criteria that should be used to determine the
information repository designation?
F. Definitions
Reproposed paragraph (j) of the Rule sets forth the definitions
applicable to all provisions of the Rule. Most of the definitions are
unchanged from the Proposing Release, but a few definitions are revised
to respond to commenters' suggestions or to add clarity to the
amendments.
Quotation Medium. The current definition of ``interdealer quotation
system'' will be incorporated into the definition of ``quotation
medium'' in paragraph (j)(12).\80\ This definition of quotation medium
is quite inclusive: it covers any publication, alternative trading
system (ATS), or other device that is used by brokers or dealers to
make known to others their interest in transactions in any security,
including offers to buy or sell at a stated price or otherwise, or
invitations of offers to buy or sell.\81\ A few ATSs expressed concern
about whether they would have to comply with the Rule's information
review requirements with regard to any covered OTC security that is
traded on their systems by broker-dealer subscribers to such ATSs.\82\
ATSs are included in the definition of ``quotation medium'' if they
display subscriber orders to any person other than ATS employees. The
Rule's information review requirements, however, apply only to the
broker-dealers that submit quotations for publication by the ATS, and
not to the ATS functioning as the quotation medium for them. The Rule
will apply to an ATS only if, as a registered broker-dealer, it
displays its own orders in the ATS.
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\80\ Under the current Rule, interdealer quotation system is
defined as any system of general circulation to brokers or dealers
which regularly disseminates quotations of identified brokers or
dealers. A separate definition of ``interdealer quotation system''
is no longer necessary because of the proposed elimination of the
piggyback provision and the revision that the information be
furnished to the NASD in accordance with NASD rules, rather than to
interdealer quotation systems.
\81\ We are using the term ``alternative trading system,'' which
encompasses the term ``electronic communications network.'' See
Securities Exchange Act Release No. 40760 (December 8, 1998), 63 FR
70844.
\82\ See e.g., Letter from Instinet (April 22, 1998).
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An issue has also been raised about whether Rule 15c2-11 applies to
broker-dealers submitting orders through an ATS. We understand that
some broker-dealers have taken the position that compliance with Rule
15c2-11 is not necessary when they submit an order through an ATS.\83\
They have viewed such an order for the security as not constituting a
quotation within the meaning of Rule 15c2-11. These orders may
represent transactions for the broker-dealer's own account. The Rule's
definition of quotation makes clear that the Rule covers any indication
of interest by a broker or dealer in receiving bids or offers from
others for a security, or any indication by a broker or dealer that it
wishes to advertise its general interest in buying or selling a
particular security. Thus, broker-dealers are subject to the Rule when
they place any indication of interest in any quotation medium,
including an ATS, that they wish to receive bids or offers in a covered
OTC security, unless they can rely on one of the Rule's exceptions.\84\
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\83\ For example, some broker-dealers have claimed to submit
customer ``orders'' in quotations mediums following the termination
of a Commission trading suspension issued under Exchange Act Section
12(k).
\84\ To rely on the exception for an unsolicited customer order,
the order must represent an unsolicited indication of interest of a
customer (other than a person acting as or for a dealer) of the
broker-dealer submitting the order to the ATS.
---------------------------------------------------------------------------
Also, we are clarifying the Rule's application to broker-dealers
that publish quotations in multiple quotation mediums or move their
quotations from one quotation medium to another. If the broker-dealer
complies with the Rule's provisions, based upon a review of
information, it may publish quotations in one or more quotation
mediums.\85\
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\85\ We have previously interpreted the Rule to require a
broker-dealer that was publishing quotations in a particular
interdealer quotation system to review issuer information before
publishing quotations in another interdealer quotation system unless
it relied upon an exemption. See Letter re: OTC Bulletin Board
Display Service (December 20, 1993) (conditional exemption
permitting broker-dealers that are currently publishing quotations
in an interdealer quotation system to publish quotations in the OTC
Bulletin Board without reviewing issuer information under the Rule);
and Letter re: OTC Bulletin Board; Modification of Exemption
(December 1, 1998) (modifying the exemption granted in 1993). Upon
adoption of the reproposed amendments, we will rescind this
interpretation and related exemptions.
---------------------------------------------------------------------------
Net tangible assets. We are proposing to add a definition to the
Rule to assist broker-dealers in assessing whether or not a security
can meet the proposed exception to the Rule for securities of issuers
with net tangible assets exceeding $10 million. Net tangible assets
means total assets less intangible assets and liabilities and this
determination must be based on the issuer's current financial
statements, which must be audited.
G. Preservation of Documents and Information
To facilitate compliance with the Rule's recordkeeping
requirements, we believe that it is appropriate to codify the Rule's
record preservation requirements in Rule 17a-4,\86\ rather than in Rule
15c2-11. Rule 17a-4 obligates broker-dealers to preserve documents and
information that they must compile pursuant to Commission rules for the
time period and in the manner specified in the various provisions of
Rule 17a-4. As in the Proposing Release, Rule 17a-4 would be amended to
add the information specified in reproposed paragraphs (c), (d), and
(e) of Rule 15c2-11 to the other information that broker-dealers are
already required to preserve under Rule 17a-4.\87\
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\86\ 17 CFR 240.17a-4. We will add new paragraph (b)(11).
\87\ This proposed recordkeeping requirement was discussed by
few commenters and generally was viewed favorably. See e.g., NASAA
Comment Letter.
---------------------------------------------------------------------------
With regard to issuer information that is accessible to broker-
dealers through our EDGAR system, any other federal or state electronic
information system,\88\ or an information repository, the amendments
provide different requirements. If broker-dealers obtain and review the
information contained on such systems, they will not need to preserve
such information separately, as long as they document the review and
the information is accessible on such system for the same period of
time that
[[Page 11136]]
the broker-dealers are obligated to preserve such information pursuant
to Rule 17a-4.
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\88\ Broker-dealers publishing quotes for securities of exempt
financial institutions may obtain the regulatory reports from the
financial institution by contacting their primary bank regulatory
agency. Broker-dealers can access the Federal Reserve System's
National Information Center of Banking Information Internet website
at <http://www.ffiec.gov/NIC>, the Office of the Comptroller of the
Currency's Internet website at <http://www.occ.treas.gov>, which has
information about individual nationally chartered banks, or the
Federal Deposit Insurance Corporation's (FDIC) Internet website at
<http://www.fdic.gov>, which provides the most recent Call Reports
for all FDIC insured banks. Broker-dealers that access exempt
financial institution information through these websites would be
able to satisfy the Rule's requirements by recording their review
and preserving the information in the same manner as for EDGAR
information discussed above.
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H. Transition and Exemptive Authority Provisions
We are reproposing the transition provision covering quotations by
broker-dealers that were initiated prior to the effective date of the
proposed amendments and, with a slight modification, the provision
giving the Commission the authority to grant exemptions from the
Rule.\89\ These proposed provisions were viewed as adequate by the few
commenters who discussed them.\90\
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\89\ The reproposal would provide the Commission with the
authority to grant an exemption from the Rule for any quotation for
a security or any class of security.
\90\ See, e.g., Florida Comment Letter.
---------------------------------------------------------------------------
I. Information submitted to the NASD
Rule 15c2-11 currently requires any broker-dealer covered by the
Rule to submit the information required under paragraph (a)(5) (i.e.,
for non-reporting issuers) to the interdealer quotation system, in the
form prescribed by the system, at least three business days before
submitting a quotation for publication. We intend to amend this
obligation by requiring broker-dealers to submit the information that
they must review only to the NASD, in accordance with the NASD's rules.
The amendments are substantially the same as originally proposed,
except for one change. Under the Proposing Release, a broker-dealer
would be in compliance with the requirement to obtain current reports
filed by a reporting issuer, if the broker-dealer obtained all current
reports filed with the Commission by an issuer as of a date up to three
business days before the earlier of the date the broker-dealer
submitted the quotations to the quotation medium and the date the
broker-dealer submitted information to the NASD. To reduce the chance
that a broker-dealer would overlook a recently filed report containing
material issuer information, we are proposing to eliminate the
reference to the date the information was submitted to the NASD. This
means that a broker-dealer would be required to obtain current reports
filed by a reporting issuer after the broker-dealer had submitted
information to the NASD, if such reports were filed more than three
business days in advance of the publication of the quotation.
IV. General Request for Comments
We solicit comment on all aspects of the amendments to Rule 15c2-
11, as well as on any other matter that might have an impact on the
reproposal discussed above. In particular, we seek comment on the
whether the reproposal will help focus the Rule on those securities and
quotations most likely to be involved in microcap fraud. Commenters are
requested to address whether there are other ways to amend the Rule
that would help reduce fraud and manipulation in the OTC market.
Commenters also are invited to address whether the Rule's text is
sufficiently clear and understandable, or whether it can be simplified
without sacrificing its purposes. We also request commenters to provide
us with their views regarding whether the original proposal, or aspects
of it, are preferable to the reproposal.
We encourage commenters to focus on the various provisions of the
reproposal and bring to our attention any compliance or other specific
issues that they may encounter if the reproposal is adopted. Commenters
are urged to provide us with their views as expeditiously as possible
so that we can complete our review of Rule 15c2-11.
V. Effects on Efficiency, Competition, and Capital Formation
Section 23(a)(2) of the Exchange Act requires the Commission, in
adopting rules under the Exchange Act, to consider the anti-competitive
effects of any rules it adopts thereunder, and to not adopt any rule
that would impose a burden on competition not necessary or appropriate
in the public interest.\91\ Furthermore, Section 3(f) of the Exchange
Act \92\ requires the Commission, when engaged in rulemaking, to
consider or determine whether an action is necessary or appropriate in
the public interest, and whether the action will promote efficiency,
competition, and capital formation.
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\91\ 15 U.S.C. 78w(a)(2).
\92\ 15 U.S.C. 78c.
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We preliminarily believe that the reproposal would not have any
anti-competitive effects that are not necessary or appropriate in the
public interest. By applying the Rule to the first broker-dealer
publishing any quotations for a security in a quotation medium and to
other broker-dealers publishing priced quotations thereafter, the
availability of information about issuers of covered OTC securities
should be increased. This should help improve the level of competition
among broker-dealers publishing priced quotations and enhance the
extent of information about OTC issuers that is available to the
investing public. Moreover, by excluding unpriced quotations from the
Rule, anti-competitive burdens will be reduced because broker-dealers
that cannot, or do not want to, obtain the specified information can
still advertise their interest in buying or selling a particular OTC
security in a quotation medium. Finally, the reproposal should have a
beneficial impact on capital formation because microcap fraud
ultimately increases the costs of raising capital for legitimate
smaller issuers. Investors may be less willing to commit their
resources if they are concerned about fraudulent activities in OTC
securities.
We request comments on the benefits, as well as the adverse
consequences, that may result with respect to efficiency, competition
and capital formation, if the reproposal is adopted.
VI. Costs and Benefits of the Amendments
We request commenters to evaluate the costs and benefits associated
with the amendments to Rule 15c2-11. We have identified certain costs
and benefits relating to the reproposal, which are discussed below, and
encourage commenters to discuss any additional costs or benefits. In
particular, we request comments on the potential costs for any
necessary modifications to information gathering, management, and
reporting systems or procedures that would be necessary to implement
the amendments, as well as any potential benefits resulting from the
reproposal for issuers, investors, broker-dealers, securities industry
professionals, regulators or others. Commenters should provide analysis
and data to support their views on the costs and benefits associated
with the amendments.
A. Benefits
Incidents of microcap fraud frequently involve issuers for which
public information is limited.\93\ Without information, it is difficult
for investors, securities professionals, and others to evaluate the
risks presented by these securities. Consequently, many investors fall
prey to persons who make false representations and unrealistic
predictions about these securities. The publication of quotations by
broker-dealers can facilitate the fraudulent promotion of microcap
securities.
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\93\ See, e.g., SEC v. Global Financial Traders, Ltd.,
Litigation Release Nos. 15291 (March 14, 1997), and 15338 (April 17,
1997).
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In our view, the reproposal generally would improve the quality of
the markets for securities subject to Rule 15c2-11 and would help
protect
[[Page 11137]]
investors from fraudulent schemes involving these securities. The
reproposal is focused on the OTC-quoted securities of smaller issuers.
Absent the amendments, we believe that some broker-dealers would submit
quotations without regard to basic information about relatively unknown
issuers. 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. Market makers in the securities of
legitimate microcap issuers, as well as the issuers themselves, also
would benefit from improving the integrity of this market sector. One
benefit of the reproposal is that the scope of the Rule will be revised
so that broker-dealers will not have to obtain information about those
securities that satisfy any one the proposed alternative tests.
We also believe that the amendments will serve an important
surveillance function. Currently, only the first broker-dealer quoting
a security in a quotation medium must gather, review, and preserve the
information. The amendments will require the first broker-dealer
initiating any quotation and all broker-dealers initiating priced
quotations thereafter to satisfy the Rule's information review
requirements. Moreover, under NASD Rule 6740,\94\ broker-dealers
demonstrate their compliance with that rule by filing the Rule 15c2-11
information with the NASD. Recently, the review of Forms 211 filed with
the NASD has resulted in a number of Commission trading suspensions and
other enforcement actions.
---------------------------------------------------------------------------
\94\ NASD Manual, Marketplace Rules, Rule 6740.
---------------------------------------------------------------------------
The amendments require broker-dealers publishing quotes in
compliance with the Rule to provide the information upon request to any
customer, prospective customer, other broker-dealers, or information
repository unless the information is available through a government
sponsored database. This amendment will help make information about
non-reporting issuers more widely available to the public.
We also believe that the amendments will ease significantly the
Rule's recordkeeping requirement because broker-dealers will not have
to retain information that is available on the Commission's EDGAR
system or on the information systems of other federal or state
authorities. Access to EDGAR and similar government-sponsored
information systems is free on the Internet. Given that approximately
60% of securities on the OTC Bulletin Board and Pink Sheets are issued
by reporting companies, whose reports are included on EDGAR, a
significant recordkeeping cost savings to broker-dealers should result.
We do not have the data to quantify the value of the benefits
described above. We seek comments on the value of these benefits and on
any benefits, not already identified, that may result from the adoption
of the amendments.
B. Costs
We anticipate that the elimination of the piggyback provision will
create the most significant costs that the industry will incur.
Currently, only those broker-dealers that publish quotations during the
first 30 days of the security's trading are required to obtain and
review the specified information before they initiate quotations. As
reproposed, the Rule will continue to require the first broker-dealer,
before initiating a priced or unpriced quotation for a covered OTC
security in a quotation medium, to review the specified information.
Thereafter, the reproposed Rule will impose the review requirement only
on broker-dealers publishing priced quotations, including in connection
with the annual review requirement. Of course, if the Commission
suspends trading under Exchange Act Section 12(k) for any of the
issuer's securities, the Rule's requirements are triggered.
The first broker-dealer, before initiating any quotation for a
covered OTC security, is currently required to incur the cost of having
to gather and review the issuer information. As a result of the
amendments, that broker-dealer will incur the cost to update that
information annually if it continues to publish priced quotations.
Thereafter, any broker-dealer publishing priced quotations for a
covered OTC security will incur costs when it first publishes a priced
quotation and when it conducts the required annual review. To the
extent a broker-dealer does not already have the required information,
it will incur costs for the collection and review of this information.
Moreover, a broker-dealer also will incur costs associated with
creating the records required by the Rule and retaining the Rule's
required information for the specified period of time under the
amendment to Rule 17a-4.
We estimate that approximately 60% of the issuers of OTC stocks are
reporting issuers, while the remaining 40% are non-reporting issuers.
Based on this assumption, broker-dealers publishing priced quotations
for the OTC securities of reporting issuers should be able to obtain
the prescribed information required by the reproposed Rule from the
Commission's EDGAR system and therefore should incur minimal costs to
comply with the Rule. We believe that it will take a broker-dealer a
maximum of 4 hours to collect, review, record, retain, and supply to
the NASD the information pertaining to a reporting issuer, and a
maximum of 8 hours to collect, review, record, retain, and supply to
the NASD the information pertaining to a non-reporting issuer.\95\ We
estimate that it will cost a broker-dealer an average cost of $40 per
hour (based on a blended compensation rate for clerical and supervisory
compliance staff) to obtain and review the necessary information
required by the Rule.\96\
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\95\ We computed these cost estimates after reviewing, among
other sources, responses to a survey of broker-dealers conducted by
the NQB about issues raised in the Proposing Release. The results of
the NQB's survey are available in File No. S7-3-98 at the
Commission's Public Reference Room, 450 Fifth Street N.W.,
Washington, D.C. 20549.
\96\ The cost estimate assumes that clerical staff are paid at
an average rate of $15 per hour and supervisory compliance staff are
paid at an average rate of $100 per hour. The blended compensation
rate assumes that 70% of the time is clerical and 30% is supervisory
compliance [(0.7 x $15) + (0.3 x $100) = $40].
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We recently approved changes to NASD Rules 6539 and 6540 to limit
the quotations on the OTC Bulletin Board to securities of issuers that
are current in their reports filed with us or other regulatory
authority, and to prohibit NASD members from quoting a security on the
OTC Bulletin Board unless the issuer has made current filings with
us.\97\ While these NASD Rule changes may result in more issuers
choosing to become reporting issuers in order to continue to qualify
for quotation on the OTC Bulletin Board, we are at this time unable to
adequately quantify the cost impact or burden that the reproposal
imposes in relation to these rule changes. However, we believe that,
generally, any increase in the number of reporting issuers subject to
the Rule will cause a reduction in the number of the burden hours and
associated costs. We are of the view that because reporting issuer
information is readily available from the Commission's EDGAR system
and, because we estimate that broker-dealers only have to spend 4 hours
reviewing reporting issuer information, instead of the estimated 8
hours to review non-reporting issuer information, the reduced time
spent reviewing issuer information will result in lower costs to
broker-dealers.
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\97\ See OTC Bulletin Board Release.
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However, broker-dealers publishing priced quotations for the OTC
securities of non-reporting issuers are likely to incur greater costs
in complying with
[[Page 11138]]
the Rule. For purposes of the Paperwork Reduction Act, we estimate the
total burden hours for all broker-dealers to be 143,278 hours and the
total cost to be $5,731,120. Some 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 priced quotes. On the other hand,
the costs broker-dealers incur in obtaining and reviewing information
about non-reporting issuers may be reduced if one or more on-line
information repositories of this information are established. We seek
comments on the reasonableness of these estimates for annual hourly and
dollar costs to broker-dealers. We also seek comments on the extent to
which these cost estimates will be affected by the new NASD rule to
limit the OTC Bulletin Board to the securities of issuers current in
their periodic filings.
Although Rule 15c2-11 does not regulate issuers, there may be some
indirect costs imposed on issuers, particularly non-reporting issuers,
because they may be contacted by broker-dealers to provide the
information specified in the Rule. Non-reporting issuers would incur
the cost of having to collect and provide the requested information to
each requesting broker-dealer. However, we are assuming that non-
reporting issuers maintain their financial information in compliance
with prevailing accounting standards and, in most instances, would have
available updated financial information prepared in accordance with
generally accepted accounting principles (GAAP). The NASD has informed
us that financial statements submitted with the Form 211 generally are
prepared in accordance with GAAP, and many are audited.
Regarding start-up, operating, and maintenance costs, we believe
that broker-dealers that collect, review, and retain the information
currently required by the Rule, would incur only marginal start-up,
operating, and maintenance costs (i.e., to expand systems already in
place) to comply with the Rule as reproposed. Further, some broker-
dealers already may be collecting the required information for other
purposes. However, we believe that some broker-dealers may not have
adequate systems in place to retain issuer information and would,
therefore, incur start-up, operating, and maintenance costs in order to
comply with the requirements of the amendments.
We estimate that about 100 broker-dealers in the aggregate will
incur start-up, operating, and maintenance costs of $100,000
($1,000 x 100) associated with reporting issuer information, and
$400,000 ($4,000 x 100) associated with non-reporting issuer
information. Total start-up, operating and maintenance cost burden for
broker-dealers is estimated to be $500,000 ($100,000+$400,000) or an
average of $5,000 for each broker-dealer.
We assume that non-reporting issuers, because they generally
maintain their financial information in compliance with prevailing
accounting standards, will not incur any start-up costs to prepare the
required information in response to broker-dealers' requests. We also
believe that reporting issuers of covered OTC securities will not incur
start-up costs as a result of the amendments since such issuers already
provide the required information to the Commission under the federal
securities laws. Therefore, we believe issuers will not incur start-up
costs as a consequence of the adoption of the Rule amendments, as
reproposed.
Finally, the Rule, as modified by the amendments, could affect the
liquidity of some securities. If broker-dealers are unable to obtain
the required issuer information, they would have to refrain from
publishing priced quotations in that security. This 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. Thus, while investors are still
able to obtain price information, the cost of obtaining this
information may increase. However, under the reproposal, after the
first quotation for a security is published, broker-dealers could
publish unpriced quotes without complying with the Rule's provisions.
In addition, broker-dealers could rely on the exception that permits
them to publish quotes representing unsolicited customer orders.
Any effect on liquidity must be weighed against the benefit of
reducing instances of fraud or manipulation. Greater investor access to
information should result in more informed investor decisions and
potentially could result in additional trading, and thus liquidity, for
covered OTC securities. We have modified the proposals to permit
broker-dealers to publish unpriced quotations for OTC securities
without reviewing the specified information (other than the first
broker-dealer to quote the security). This revision responds to the
views of those commenters that expressed concerns about the Rule's
impact on liquidity.
VII. Initial Regulatory Flexibility Act
We have prepared an Initial Regulatory Flexibility Analysis (IRFA)
\98\ regarding the amendments to Rule 15c2-11 and the reproposed
companion amendment to Rule 17a-4 under the Exchange Act. The following
summarizes the IRFA.
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\98\ See 5 U.S.C. 603.
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As discussed in the IRFA, the amendments specify the information
that a broker-dealer must gather and review before publishing
quotations for covered OTC securities. The reproposed Rule is intended
to prevent broker-dealers from publishing quotations for covered OTC
securities in a quotation medium without obtaining, reviewing, and
retaining current information about the issuer. The reproposed Rule
applies primarily to priced quotations.
The amendments to the Rule would affect all broker-dealers,
including a number of small broker-dealers, seeking to publish
quotations for covered OTC securities.\99\ The number of small broker-
dealers that publish quotations for covered OTC securities in quotation
mediums is not known at this time. However, we recently estimated that
about 13% of all registered broker-dealers would be characterized as
small.\100\ We estimate that, at any given time, there are
approximately 400 broker-dealers, including small broker-dealers, that
submit quotations for covered OTC securities. Therefore, based on this
estimate, we believe that approximately 52 small broker-dealers
(400 x 13%) would be affected by the amendments. In fact, it is
possible that few, if any, broker-dealers publishing quotations for
covered OTC securities would be classified as a small business, because
as market makers they typically require more than $500,000 in capital
to support their market making activities. In the Proposing Release, we
solicited but did not receive any comments on the number of small
broker-dealers that would be affected by the amendments. We are again
soliciting comments on the number of small broker-dealers that would be
affected by the amendments.
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\99\ For purposes of the regulatory flexibility analysis, a
broker-dealer is considered ``small'' if its total capital is less
than $500,000, and is not affiliated with a broker-dealer that has
$500,000 or more in total capital.
\100\ See Securities Exchange Act Release No. 40122 (June 24,
1998), 63 FR 35508 (adopting amendments to the definitions of
``small business'' or ``small organization'' under the Investment
Company Act of 1940, the Investment Advisers Act of 1940, the
Securities Exchange Act of 1934, and the Securities Act of 1933).
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The amendments would indirectly have an impact on those small
issuers that may be requested to provide the information required by
the Rule to
[[Page 11139]]
broker-dealers publishing quotations in those issuers' securities.
Based on Exchange Act Rule 0-10(a), a small issuer is one that on the
last day of its most recent fiscal year had total assets of $5,000,000
or less. In the Proposing Release, we solicited but did not receive any
comments on the total number of issuers of covered OTC securities; the
number (or percentages) of these issuers that are small issuers; and
the total number (or percentage) of small issuers of covered OTC
securities that are reporting and non-reporting issuers, respectively.
We are again seeking comments on these issues.
The IRFA notes that the availability of the Commission's EDGAR
system and similar systems sponsored by federal or state authorities
should assist broker-dealers in collecting and reviewing the reports
required by the Rule. In addition, the prevalent use of computers and
the Internet, on which access to EDGAR is free, should also reduce the
recordkeeping and compliance costs for all broker-dealers by automating
the information collection and retention process.
The IRFA recognizes that the amendments indirectly affect certain
issuers, particularly non-reporting issuers. The amendments would
require the first broker-dealer to publish any quotation for a covered
security to review the Rule's information. Thereafter, other broker-
dealers must review information about the issuer when they first
publish or resume publishing a priced quotation for a covered security,
and all broker-dealers publishing priced quotations must conduct an
annual review. We are not aware of any information repository,
electronically accessible or otherwise, now in existence that covers
all of the information about non-reporting issuers that broker-dealers
must gather to comply with the Rule. Consequently, non-reporting
issuers must collect and provide the required information to each
requesting broker-dealer. We assume that non-reporting issuers maintain
their financial information in compliance with generally accepted
accounting standards and that the costs incurred by non-reporting
issuers to prepare the necessary information in response to broker-
dealers' requests would be minimal.
The IRFA discusses the kinds of possible alternative proposals that
we have considered. These include, among others, creating differing
compliance or reporting requirements or timetables that take into
account the resources available to small entities, and whether such
entities could be exempted from the reproposed rule, or any part
thereof. Therefore, having considered the foregoing alternatives in the
context of the amendments, we do not believe they would accomplish the
stated objectives of the proposal.
We encourage the submission of written comments regarding any
aspect of the IRFA. In particular, we seek comments on: (i) the number
of small entities that would be affected by the amendments, including
the number of small broker-dealers and issuers; (ii) the number of
small entities that are issuers of covered OTC securities; and (iii)
the number of small entities that are reporting and non-reporting
issuers of covered securities, respectively. Comments should also
specify the costs of compliance with the amendments, and suggest
alternatives that would meet the objectives of the amendments in a more
effective manner, while imposing costs equal to or less than the
amendments. In describing the nature of any impact that the amendments
would have, empirical data supporting these views should be provided.
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, we are also requesting information regarding the potential
impact of the proposed amendments on the economy on an annual basis. In
particular, comments should address whether the proposed changes, if
adopted, would have a $100,000,000 annual effect on the economy, cause
a major increase in costs or prices, or have a significant adverse
effect on competition, investment, or innovations. Commenters should
provide empirical data to support their views.
Comments should be submitted in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW,
Washington, DC 20549. Comments may also be submitted electronically at
the following E-mail address: [email protected]. All comment
letters should refer to File No. S7-5-99; this file number should be
included on the subject line if E-mail is used. Comment letters will be
available for public inspection and copying in the Commission's Public
Reference Room, 450 Fifth Street, NW, Washington, DC 20549.
Electronically submitted comment letters will also be posted on the
Commission's Internet website (http://www.sec.gov).
A copy of the Initial Regulatory Flexibility Analysis may be
obtained by contacting Chester A. McPherson, Office of Risk Management
and Control, Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street, NW, Washington, DC 20549, at (202) 942-
0772.
VIII. Paperwork Reduction Act
Certain provisions of the amendments contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (PRA).\101\ The title for the collection of
information is: ``Publication or submission of quotations without
specified information.'' Accordingly, the collection of information
requirements contained in the Rule and the initial proposal were
submitted to the Office of Management and Budget (OMB) for review, in
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11, and were approved
by OMB. The Rule has been assigned OMB Control No. 3235-0202.\102\
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\101\ 44 U.S.C. 3501 et seq.
\102\ The Commission notes that a separate PRA filing was not
prepared to reflect the proposed companion changes to Rule 17a-4.
The burden hours and costs described for the Rule include and
account for the anticipated burdens that may arise as a result of
the proposed change to Rule 17a-4.
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A. Collection of Information Under the Amendments
As reproposed, the Rule would require the first broker-dealer,
before initiating a priced or unpriced quotation for a covered OTC
security in a quotation medium, to gather and review the issuer
information, and to review updated information annually if it continues
to publish priced quotations. This review requirement would also be
imposed on any other broker-dealer publishing a priced quotation for a
covered OTC security. Broker-dealers submitting priced quotations for
the security would be required to collect, review, and retain the
Rule's specified information annually. Broker-dealers would also have
to record the sources of their information, the date their review
occurred, and the person responsible for the review. Also, the
proposals would require broker-dealers publishing quotations for a
covered OTC security to collect, review, and retain more information
than is required currently.
Under Rule 15c2-11, the information that is collected pursuant to
the Rule must be submitted to the NASD at least three business days
before any quotation is published.\103\ Finally, the amendments would
require broker-dealers to provide the information specified to any
customer, prospective customer, other broker-dealer or information
repository that requests it.
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\103\ The NASD has a rule requiring broker-dealers that initiate
or resume quotations for covered equity securities to submit
verification that they have collected the information necessary to
comply with NASD requirements, as well as Rule 15c2-11. See NASD
Manual, Marketplace Rules, Rule 6740.
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[[Page 11140]]
B. Proposed Use of Information
Broker-dealers must collect and review the information required
under the amendments if they publish the first quotation for a covered
OTC security or if they publish priced quotations. Moreover, the Rule
requires that broker-dealers have a reasonable basis for believing that
the information about the issuer and related persons is accurate and
from reliable sources. This information collection protects investors
by deterring fraudulent or manipulative quotations for thinly-traded
securities whose issuers are relatively unknown. Because information
about these issuers is not widely disseminated and often is not
current, fraudulent and manipulative schemes are easier to perpetrate.
Moreover, this collection of information helps broker-dealers guard
against becoming unwitting participants in fraudulent or manipulative
schemes. The Rule 15c2-11 information gathering requirements also serve
an important surveillance function for both the Commission and the
NASD. Recently, the Commission has used the Rule 15c2-11 information to
suspend trading in the issuers' securities pursuant to Section 12(k) of
the Exchange Act where publicly available information about the issuer
raised questions about the accuracy and adequacy of the issuers'
disclosures.
C. Respondents
The amendments would apply to those broker-dealers that publish
quotations for a covered OTC security in a quotation medium as of
specified quotation events. The amendments also indirectly affect
issuers that are asked by broker-dealers to provide this information.
Most of the Rule 15c2-11 information that would be required for issuers
that publicly file periodic reports with the Commission (reporting
issuers) is available electronically on EDGAR or through the Internet.
Thus, the reproposal is likely to have a greater paperwork burden when
broker-dealers publish quotations for the securities of issuers that do
not participate in the Commission's public reporting program, (i.e.,
non-reporting issuers) or do not file reports with other federal or
state regulatory authorities.
D. Total Annual Reporting and Recordkeeping Burden
The amendments would require broker-dealers to collect, review,
retain, and record certain issuer and supplemental information when
they are the first broker-dealer to quote the security; when they first
publish priced quotations for a covered OTC security; and if they are
publishing priced quotations as of the annual review requirement. The
discussion below estimates the collection of information burden one
year after the anticipated date of effectiveness of the amendments when
broker-dealers that publish quotes for covered OTC securities
qualifying for the reproposed transition provision must fully comply
with the Rule's information requirements. The discussion below also
provides estimates for the same period for issuers that may be
contacted to provide the information. In particular, the following
analysis measures the cost to broker-dealers of: (1) collecting,
reviewing, recording, and retaining the required issuer information and
supplying it to the NASD; (2) responding to requests for issuer
information from customers, prospective customers, other broker-dealers
and information repositories; and (3) starting up or maintaining
systems for the collection and retention of issuer information. The
analysis below also addresses the indirect cost to issuers who must
furnish information to requesting broker-dealers.
1. Burden-Hours for Broker-Dealers
Based on information provided by the NASD and NQB, we estimate that
as of December 31, 1998, there were approximately 6,625 covered OTC
securities quoted in the OTC Bulletin Board and 3,225 quoted in the
Pink Sheets for a total of 9,850 covered OTC securities.\104\ We also
believe that approximately 10% (985) of these securities would not be
subject to the Rule, based on the exceptions that are included in this
reproposing Release and that approximately 8,865 securities would be
subject to the Rule. According to NASD estimates, we also believe that
approximately 1,400 new applications from broker-dealers to initiate or
resume publication of covered equity securities in the OTC Bulletin
Board and/or the Pink Sheets or other quotation mediums were approved
by the NASD for the 1998 calendar year. We have estimated that 60% of
the covered OTC securities were issued by reporting issuers, while the
other 40% were issued by non-reporting issuers. We also estimate that
broker-dealers publish priced quotations for approximately 90% of the
covered OTC securities quoted in the OTC Bulletin Board and publish
priced quotes for about 10% of the covered OTC securities quoted in the
Pink Sheets. According to NASD and NQB estimates, we believe that, on
average, there are approximately 4.3 broker-dealers publishing priced
quotations for each covered OTC security, and that at any given time
there are no more than 400 broker-dealers that submit priced quotations
for covered OTC securities. Finally, the reproposed Rule's transition
provision would not subject the broker-dealers quoting the securities
of the estimated 8,865 potentially covered securities currently quoted
in the OTC Bulletin Board and/or the Pink Sheets until the annual
review requirement is triggered. Therefore, only those new applications
that are submitted after the reproposal becomes effective would be
subject to the initial review requirement.
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\104\ We recognize that there may be covered OTC securities
quoted in other quotation mediums, but at this time we do not have
the empirical data to include them in our estimations.
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Because the amendments would require the first broker-dealer
publishing a quotation, priced or unpriced, for a particular security
to collect issuer information, we believe that during the first year
after the amendments are effective, broker-dealers that are publishing
the first quotations (whether priced or unpriced) for covered OTC
securities in the aggregate would have to conduct approximately 1,260
initial reviews of issuer information.\105\ We believe that it will
take a broker-dealer about 4 hours to collect, review, record, retain,
and supply to the NASD the information pertaining to a reporting
issuer, and about 8 hours to collect, review, record, retain, and
supply to the NASD the information pertaining to a non-reporting
issuer.
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\105\ This estimate is based on the assumption that the NASD
will, in the first year after the reproposal becomes effective,
approve 10% fewer Form 211 filings than the 1,400 applications
approved in 1998.
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We therefore estimate that after the reproposal has become
effective, the broker-dealers who are the first to publish the first
quote for a covered OTC security of a reporting issuer (priced or
unpriced) will require 3,024 hours (1,260 x 60% x 4) to collect,
review, record, retain, and supply to the NASD the information required
by the Rule as reproposed. We estimate that after the reproposal has
become effective the broker-dealers who are the first to publish the
first quote for a covered OTC security of a non-reporting issuer
(priced or unpriced) will require 4,032 hours (1,260 x 40% x 8) to
collect, review, record, retain, and supply to the NASD the information
required by the Rule as reproposed. We therefore estimate the total
annual burden hours for the first broker-dealers to be 7,056 hours
(3,024+4,032).
The Rule also would require an annual review for broker-dealers
[[Page 11141]]
publishing priced quotations for covered OTC securities. We have
estimated that each issuer is quoted by about 4.3 broker-dealers. We
are assuming that of the universe of approximately 8,865 potentially
affected covered OTC securities, broker-dealers would publish priced
quotations for approximately 90% of the OTC Bulletin Board securities
or 5,366 securities ((6,625 x 90%) x 90%) and for 10% of the Pink Sheet
securities or 290 securities (3,225 x 90%) x 10%).\106\ Therefore, we
estimate that priced quotations will be published for approximately
5,656 (5,366+290) covered OTC securities. Given that about 60% of OTC
stocks are issued by reporting issuers and the other 40% by non-
reporting issuers, and that it would take a broker-dealer 4 and 8
hours, respectively, to meet the requirements of the reproposed Rule
for these issuers, we estimate the burden hours as follows: for
reporting issuers we estimate approximately 58,375 hours
(3,394 x 4.3 x 4), and for non-reporting issuers we estimate
approximately 77,847 hours (2,263 x 4.3 x 8). Therefore, we estimate
the total annual paperwork burden hours for all broker-dealers to be
143,278 hours (7,056+58,375+77,847).
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\106\ Some securities have priced quotations published in both
of these quotation systems. To avoid double counting, such
securities are counted as OTC Bulletin Board securities.
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2. Burden-Hours for Issuers
Regarding the burden on issuers to provide broker-dealers with the
required information, we believe that the 5,319 issuers of covered OTC
securities (based on our estimate that 60% of the 8,865 potentially
covered OTC securities are reporting issuers) will not bear any
additional hourly burdens under the amendments because these issuers
already report the required information to the Commission through
mandated periodic filings. Further, reporting issuer information is
widely available to broker-dealers through a variety of media. However,
non-reporting issuer information is not widely available. Consequently,
these issuers must provide the information required by the amendments
to requesting broker-dealers before quotations in their securities can
be published. We believe that the 3,546 issuers of non-reporting
covered OTC securities (based on an estimate that 40% of the 8,865
potentially covered OTC securities are non-reporting ) will spend an
average of 9 hours each to collect, prepare, and supply the information
required by the proposals to the first broker-dealer that requests this
information. Thereafter, we estimate that it will take an average of 1
hour for an issuer to provide the same information to the remaining 3.3
broker-dealers that request the information. Accordingly, we estimate
the 3,546 non-reporting issuers annually will incur 31,914 hours
(3,546 x 9 x 1) to comply with the first broker-dealer's request for
information, and 11,702 hours (3,546 x 1 x 3.3) to comply with the
subsequent 3.3 broker-dealer requests for an annual total of 43,616
burden hours (31,914+11,702). On average, therefore, each non-reporting
issuer would spend approximately 12.3 burden hours (43,616/3,546) per
year to comply with these requests.
3. Total Burden-Hour Costs to Broker-Dealers and Issuers
We estimate the collection of information will require
approximately 186,894 burden hours annually (143,278 + 43,616) from
approximately 3,946 respondents (400 broker-dealers and 3,546 issuers).
4. Capital Cost to Broker-Dealers and Issuers
We believe that broker-dealers that now collect, review, and retain
the information required by the current Rule will not incur any
significant start-up costs to expand systems already in place. Further,
broker-dealers that are collecting the information required by the
proposals for other purposes also will not incur significant start-up
costs. However, we believe some broker-dealers may not have adequate
systems in place to retain issuer information and will incur start-up
costs in order to comply with the requirements of the amendments. We
assume that of the 400 broker-dealers that provide quotations for
covered OTC securities, about 100 broker-dealers will incur additional
start-up costs, while the remaining 300 broker-dealers will only incur
incremental costs. Because the information for reporting issuers will
be generally available on EDGAR and such availability satisfies the
recordkeeping requirements of the proposals, we are assuming that the
start-up costs associated with retaining information on reporting
issuers will average $1,000 per broker-dealer, whereas the same costs
will be $4,000 per broker-dealer for non-reporting issuer information.
We estimate that broker-dealers in the aggregate will incur start-up,
operating, and maintenance costs of $100,000 ($1,000 x 100)
associated with reporting issuer information, and $400,000 ($4,000 x
100) associated with non-reporting issuer information. Total start-up,
operating and maintenance cost burden for broker-dealers is estimated
to be $500,000 ($100,000 + $400,000) or an average of $5,000 for each
broker-dealer.
We assume that non-reporting issuers, because they maintain their
financial information in compliance with prevailing accounting
standards, will not incur any start-up costs to prepare the required
information in response to broker-dealers' requests. We also believe
that reporting issuers of covered OTC securities will not incur start-
up costs as a result of the amendments since such issuers already
provide the required information to the Commission under the federal
securities laws. Therefore, we believe issuers will not incur start-up
costs as a consequence of the adoption of the Rule amendments, as
reproposed.
E. General Information About the Collection of Information
The collection of information under the amendments is mandatory and
would be required at periodic intervals: by the first broker-dealer to
publish any quote for a covered OTC security, by broker-dealers
publishing priced quotes thereafter, and by broker-dealers publishing
priced quotes at the time of the annual review requirement. Broker-
dealers would be required to retain the information they collect for a
period of not less than three years. Information collected under the
Rule would not be kept confidential. Any agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid control number.
F. Request for comments
Pursuant to 44 U.S.C. 3506(c)(2)(B), we are soliciting comments to:
(i) evaluate whether the reproposed collection of information is
necessary for the proposed performance of the functions of the agency,
including whether the information will have practical utility;
(ii) evaluate the accuracy of our estimates of the burden of the
reproposed collection of information;
(iii) enhance the quality, utility, and clarity of the information
to be collected; and
(iv) minimize the burden of collection of information on those who
are to respond, including through the use of automated collection
techniques or other forms of information technology. We seek data about
quotations for covered OTC securities in OTC quotation mediums other
than the OTC Bulletin Board and the Pink Sheets. We seek comments on
our estimate of the number of issuers affected by the reproposed Rule
and on the time estimates made for broker-dealers and
[[Page 11142]]
issuers to comply with the information collection requirements.
Persons desiring to submit comments on the collection of
information requirements should direct them to the Office of Management
and Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Room 10102,
New Executive Office Building, Washington, DC 20503, and should also
send a copy of their comments to Jonathan G. Katz, Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW, Washington,
DC 20549, and refer to File No. S7-5-99. OMB is required to make a
decision concerning the collections of information between 30 and 60
days after publication of this release in the Federal Register, so a
comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of this publication.
IX. Statutory Basis and Text of Proposed Amendments and Rule
The rule amendments are being proposed pursuant to Sections 3,
10(b), 15(c), 15(g), 17(a), and 23(a) of the Securities Exchange Act of
1934, 15 U.S.C. Secs. 78c, 78j(b), 78o(c), 78o(g), 78q(a), and 78w(a).
List of Subjects in 17 CFR Part 240
Broker-dealers, Fraud, Reporting and recordkeeping requirements,
Securities.
Text of Reproposed Rule
In accordance with the foregoing, Title 17, chapter II, part 240 of
the Code of Federal Regulations is proposed to be amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for part 240 continues to read, in part,
as follows:
Authority: 15 U.S.C. Secs. 77c, 77d, 77g, 77j, 77s, 77z-2,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1,
78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x,
78ll(d), 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-
4 and 80b-11, unless otherwise noted.
* * * * *
2. Section 240.15c2-11 and the section heading are revised to read
as follows:
Sec. 240.15c2-11 Publication or submission of quotations without
current information.
Preliminary Note: As a means reasonably designed to prevent
fraudulent, deceptive, or manipulative acts or practices, this
section prevents a broker or dealer from publishing a quotation for
a security or, directly or indirectly, submitting a quotation for a
security for publication in a quotation medium, unless the broker or
dealer complies with the provisions of this section or relies on an
exception contained in paragraph (h) of this section. As used in
this section, the term ``you'' refers to a broker or dealer.
(a) When a broker or dealer must comply with this section. You must
comply with paragraph (b) of this section when you publish:
(1) The first quotation for a security;
(2) The first quotation following the termination of a Commission
trading suspension ordered pursuant to section 12(k) of the Act (15
U.S.C. 78l(k)) in any security of the issuer of the suspended security;
(3) Your first quotation at a specified price for the same security
after another broker or dealer publishes the first quotation for a
security as described in paragraph (a)(1) or (a)(2) of this section;
(4) A quotation at a specified price for a security after a period
of five or more consecutive business days when you did not publish any
quotations at a specified price for that security;
(5) Your first quotation at a specified price for a security after
the date that is four months after the end of the issuer's fiscal year,
unless the issuer is a foreign private issuer; or
(6) Your first quotation at a specified price for a security of a
foreign private issuer after the date that is seven months after the
end of the issuer's fiscal year.
(b) The steps a broker or dealer must take to comply with this
section. For each security in which you publish any of the quotations
listed in paragraph (a) of this section, you must:
(1) Review the issuer information described in paragraph (c) of
this section and the supplemental information described in paragraph
(d) of this section;
(2) Determine that you have a reasonable basis under the
circumstances for believing that the issuer information described in
paragraph (c) of this section, when considered in conjunction with the
supplemental information described in paragraph (d) of this section, is
accurate in all material respects and was obtained from reliable
sources;
(3) Make a record of:
(i) The issuer information described in paragraph (c) of this
section, the supplemental information described in paragraph (d) of
this section, and the sources from which you obtained the information.
You will be considered to have obtained the issuer information
described in paragraphs (c) or (d)(1) of this section if you obtained
it through the EDGAR system, any other federal or state electronic
information system, or an electronic information system operated by an
information repository, and you have the means to access the
information for the period required under Sec. 240.17a-4(b)(11);
(ii) Any significant relationship information described in
paragraph (e) of this section;
(iii) The date that you reviewed the information described in
paragraphs (c), (d), and (e) of this section; and
(iv) The person responsible for your compliance with the
requirements of this section; and
(4) Preserve the records required to be made under paragraph (b)(3)
of this section in accordance with Sec. 240.17a-4(b)(11).
(c) The issuer information that a broker or dealer must review. The
type of information that is considered ``issuer information'' and that
must be reviewed under paragraph (b) of this section depends on the
status of the issuer.
(1) Issuers with a recent public offering. If the issuer filed a
registration statement under the Securities Act (other than a
registration statement on Form F-6 (17 CFR 239.36)) that became
effective less than 90 calendar days before you publish the quotation,
and that is not the subject of a stop order, the issuer information is
the prospectus specified by section 10(a) of the Securities Act (15
U.S.C. 77j(a)).
(2) Issuers with a recent Regulation A offering. If the issuer
filed a notification under Regulation A under the Securities Act (17
CFR 230.251 through 230.263) and was authorized to commence the
offering less than 40 calendar days before you publish a quotation, and
the offering circular provided for under Regulation A is not the
subject of a suspension order, the issuer information is the offering
circular.
(3) Certain reporting issuers. If the issuer is current in filing
annual or semi-annual reports required under section 13 or 15(d) of the
Act (15 U.S.C. 78m or 78o(d)) or section 30(a) of the Investment
Company Act of 1940 (15 U.S.C. 80a-29(a)), the issuer information is
the issuer's most recent annual or semi-annual report and any quarterly
and current reports filed by the issuer after such annual or semi-
annual report. You will be considered in compliance with the
requirement to obtain current reports filed by the issuer if you obtain
all current reports filed by that issuer as of the date that is three
business days before you publish the quotation. However, until the
issuer has filed its first annual or semi-annual report, the issuer
information is:
(i) The prospectus specified by section 10(a) of the Securities Act
(15
[[Page 11143]]
U.S.C. 77j(a)) that was included in a registration statement filed by
the issuer under the Securities Act and that became effective within
the prior 15 months; or
(ii) The registration statement filed by the issuer under section
12 of the Act (15 U.S.C. 78l) that became effective within the prior 15
months (other than a registration statement on Form F-6 (17 CFR
239.36)), and any quarterly and current reports filed by the issuer
after the registration statement became effective.
(4) Certain financial institutions. If the issuer is not required
to file reports under sections 13 or 15(d) of the Act and is a bank or
savings association, as those terms are defined in 12 U.S.C. 1813, the
issuer information is the issuer's most recent annual report and any
subsequent reports filed with the issuer's appropriate Federal banking
agency or State bank supervisor, as those terms are defined in 12
U.S.C. 1813.
(5) Certain exempted insurance companies. If the issuer is exempt
from section 12(g) of the Act (15 U.S.C. 78l(g)) by complying with
section 12(g)(2)(G) of the Act (15 U.S.C. 78l(g)(2)(G)), the issuer
information is the issuer's most recent annual statement referred to in
section 12(g)(2)(G)(i) of the Act (15 U.S.C. 78l(g)(2)(G)(i)).
(6) Other issuers. If the issuer is not covered by paragraphs
(c)(1) through (c)(5) of this section, the issuer information is the
information listed below in paragraphs (c)(6)(i) through (c)(6)(xiii)
of this section. Except as specified in paragraph (c)(6)(xiii) of this
section, this information is presumed to be current if it is as of a
date within 12 months before you publish the quotation and must be the
most current information that you know or have reason to know is
available:
(i) The exact name of the issuer and any predecessor;
(ii) The address and telephone number of the issuer's principal
executive offices;
(iii) The state of incorporation of the issuer, if it is a
corporation;
(iv) The date on which the issuer's fiscal year ends;
(v) For each class of the issuer's securities outstanding:
(A) The exact title of the security;
(B) The par or stated value of the security;
(C) The number of securities or total principal amount outstanding
of the security;
(D) The class and number of securities issuable upon the security's
exercise, exchange or conversion, if applicable; and
(E) The total number of securityholders of record for the security
as of the end of the issuer's most recent fiscal year or a more recent
date;
(vi) The exact title and class of the security to be quoted;
(vii) The name, address and telephone number of the transfer agent;
(viii) A description of the issuer's business and facilities;
(ix) A description of the issuer's products or services;
(x) The full names and business addresses of the executive
officers, directors, general partners, promoters, and control persons
of the issuer, and the number of securities of each class of the
issuer's securities that are beneficially owned by each such person as
of the end of the issuer's last fiscal year or a more recent date;
(xi) The following information:
(A) A description of any of the following actions to which any
executive officer, director, general partner, promoter, or control
person of the issuer has been the subject during the prior five years:
(1) A conviction in a criminal proceeding or named as a defendant
in a pending criminal proceeding (excluding traffic violations and
other minor offenses);
(2) The entry of an order, judgment, or decree, not subsequently
reversed, suspended or vacated, by a court of competent jurisdiction
that permanently or temporarily enjoins, bars, suspends or otherwise
limits involvement in any type of business, securities, commodities, or
banking activities;
(3) A finding or judgment by a court of competent jurisdiction (in
a civil action), the Commission, the Commodity Futures Trading
Commission, or a state securities regulator of a violation of federal
or state securities or commodities law, which has not been reversed,
suspended, or vacated; and
(4) The entry of an order by a self-regulatory organization that
permanently or temporarily bars, suspends or otherwise limits
involvement in any type of business or securities activities; or
(B) A statement from the issuer that no executive officer,
director, general partner, promoter, or control person of the issuer is
the subject of any of the actions listed in paragraphs (c)(6)(xi)(A)(1)
through (4) of this section; or
(C) A description of the steps you have taken to obtain from the
issuer the information needed to comply with paragraphs (c)(6)(xi)(A)
or (c)(6)(xi)(B) of this section and a statement that the issuer failed
or refused to provide this information;
(xii) The following information:
(A) A description of any of the following events involving the
issuer, its predecessor, or any of its majority-owned subsidiaries that
occurred in the prior two years:
(1) A change in control;
(2) An increase of 10% or more of the same class of outstanding
equity securities;
(3) A merger, acquisition, or business combination;
(4) An acquisition or disposition of significant assets;
(5) A bankruptcy proceeding; and
(6) The delisting of securities by any securities exchange or
Nasdaq; or
(B) A statement from the issuer that the issuer, its predecessor,
and its majority-owned subsidiaries have not been the subject of any of
the actions or events listed in paragraphs (c)(6)(xii)(A)(1) through
(6) of this section; or
(C) A description of the steps you have taken to obtain from the
issuer the information needed to comply with paragraphs (c)(6)(xii)(A)
or (c)(6)(xii)(B) of this section and that the issuer failed or refused
to provide this information; and
(xiii) The financial information listed below in paragraphs
(c)(6)(xiii)(A) or (c)(6)(xiii)(B) and (c)(6)(xiii)(C) of this section:
(A) If the issuer is not a foreign private issuer, the issuer's
most recent balance sheet, statement of cash flows, statement of
comprehensive income, and statement of operations (income), prepared in
accordance with U.S. generally accepted accounting principles. Unless
you know or have reason to know that more current information is
available, this information will be presumed to be current if:
(1) The balance sheet is as of a date that is less than 15 months
before you publish the quotation;
(2) The statement of cash flows, statement of comprehensive income,
and statement of operations (income) are for the 12 months preceding
the date of such balance sheet; and
(3) If the balance sheet is as of a date that is more than 6 months
before you publish the quotation, it must be accompanied by an
additional statement of cash flows, statement of comprehensive income,
and statement of operations (income) for the period from the date of
such balance sheet to a date that is less than 6 months before you
publish the quotation.
(B) If the issuer is a foreign private issuer, the issuer's most
recent balance
[[Page 11144]]
sheet and statement of operations (income), and to the extent prepared
by the issuer, statement of cash flows, statement of comprehensive
income, and statement of changes in shareholders' equity, prepared in
accordance with a comprehensive body of accounting principles. Unless
you know or have reason to know that more current information is
available, this information will be considered current if:
(1) The balance sheet is as of a date that is less than 18 months
before you publish the quotation;
(2) The statement of cash flows, statement of comprehensive income,
statement of operations (income), and statement of changes in
shareholders' equity are for the 12 months preceding the date of such
balance sheet; and
(3) If the balance sheet is as of a date that is more than 9 months
before you publish the quotation, it must be accompanied by an
additional statement of cash flows, statement of comprehensive income,
statement of operations (income), and statement of changes in
shareholders' equity for the period from the date of such balance sheet
until a date that is less than 9 months before you publish the
quotation, if any such statements have been prepared by the issuer.
(C) The same financial information required by paragraph
(c)(6)(xiii)(A) and (B) of this section for such part of the two
preceding fiscal years as the issuer or any predecessor has been in
existence (one year with respect to the balance sheet), prepared in
accordance with U.S. generally accepted accounting principles (or
prepared in accordance with a comprehensive body of accounting
principles in the case of a foreign private issuer). However, if the
issuer has emerged from reorganization pursuant to Chapter 11 of the
Bankruptcy Code (11 U.S.C. 1101 et seq.) and the reorganization plan
has been in effect less than two years, the financial information
required under this paragraph (c)(6)(xiii) is the court-approved
disclosure statement filed under 11 U.S.C. 1125 and the financial
information described in this paragraph (c)(6)(xiii) from the date of
the entry of the bankruptcy court order confirming the issuer's
reorganization plan pursuant to 11 U.S.C. 1129.
(d) The supplemental information that a broker or dealer must
review. The type of information that is considered ``supplemental
information'' and that you must review under paragraph (b) of this
section is the following:
(1) A copy of any trading suspension order issued by the Commission
under section 12(k) of the Act (15 U.S.C. 78l(k)) for any securities of
the issuer or its predecessor (if any) during the 12 months before you
publish the quotation, or a copy of the public release issued by the
Commission announcing such trading suspension order; and
(2) A copy or 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.
(e) The significant relationship information that the broker or
dealer must make and keep a record of. The type of information that is
considered ``significant relationship'' information and that you must
make and keep a record of under paragraph (b) of this section is the
following:
(1) Any direct or indirect affiliation between the issuer and you
or between the issuer and any of your associated persons;
(2) Whether you are publishing the quotation on behalf of any other
broker or dealer, or any of its associated persons, and, if so, the
name of such broker or dealer, or the associated person, and the terms
of the arrangement;
(3) Whether you have received, or have any arrangement to receive,
any monetary or other consideration from any person for publishing the
quotation and, if so, a description of the consideration and the name
of the person providing the consideration; and
(4) Whether you are publishing the quotation directly or indirectly
on behalf of the issuer, or any executive officer, director, general
partner, promoter, control person, or any person, who is directly or
indirectly the beneficial owner of more than 10 percent of the
outstanding units or shares of any equity security of the issuer, and,
if so, the name of such person, and the basis for any exemption under
the federal securities laws for any sales of such securities on behalf
of such person.
(f) The information a broker or dealer must submit to the NASD. At
least three business days before you publish a quotation covered by
paragraph (a) of this section, you must submit to the NASD, in
accordance with NASD rules, the information required in paragraphs (c),
(d), and (e) of this section.
(g) The broker or dealer must make certain information required by
this section available upon request.
(1) If you publish a quotation for a security in compliance with
this section, you must make the issuer, supplemental, and significant
relationship information specified in paragraphs (c)(5), (c)(6), (d),
and (e) of this section promptly available upon request to any
customer, prospective customer, other broker or dealer, or information
repository. By providing this information to others under this
paragraph (g), you do not represent that the information is accurate;
rather, 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; but
(2) You do not need to comply with paragraph (g)(1) of this section
to the extent that the information is reasonably available through
EDGAR, any other federal or state electronic information system, or an
information repository.
(h) When a broker or dealer is not required to comply with this
section. You are not required to comply with this section when you
publish a quotation for:
(1) A security that is listed on a national securities exchange or
Nasdaq; is traded on such exchange or Nasdaq on the same day as, or on
the business day immediately before, the day you publish the quotation;
and is not suspended, terminated, or prohibited from trading on such
exchange or Nasdaq;
(2) An exempted security, as defined in section 3(a)(12) of the Act
(15 U.S.C. 78c(a)(12));
(3) A security where the quotation represents the unsolicited order
of a customer (other than a person acting as or for a dealer);
(4) A non-convertible debt security or a non-participatory
preferred stock;
(5) An asset-backed security that is rated by at least one
nationally recognized statistical rating organization, as that term is
used in Sec. 240.15c3-1, in one of its generic rating categories that
signifies investment grade;
(6) A security with a worldwide average daily trading volume value
of at least $100,000 during each month of the six full calendar months
immediately before the date you publish the quotation;
(7) A convertible security, if the underlying security meets the
requirements of paragraph (h)(6) of this section;
(8) A security that has bid price, as published on a national
securities exchange, Nasdaq, or quotation medium, of at least $50 per
share. If the security is a unit composed of one or more securities,
the bid price of the unit divided by the number of shares of the unit
that are not warrants, options,
[[Page 11145]]
rights, or similar securities must be at least $50; or
(9) A security of an issuer that has net tangible assets in excess
of $10,000,000.
(i) The steps to take to become an information repository.
(1) An entity seeking information repository designation must file
an application with the Director of the Commission's Division of Market
Regulation in Washington, DC. The application should provide detailed
information explaining how the entity satisfies the attributes set
forth in paragraph (i)(2) of this section. The entity must also file
any additional information relating to the attributes set forth in
paragraph (i)(2) of this section that the Director of the Commission's
Division of Market Regulation subsequently requests;
(2) In determining whether to designate an entity as an information
repository, the Commission will consider whether the entity:
(i) Collects information about a substantial segment of issuers of
securities subject to this section;
(ii) Maintains current and accurate information about such issuers;
(iii) Has effective acquisition, retrieval, and dissemination
systems;
(iv) Places no inappropriate limits on the issuers from or about
which it will accept information;
(v) Provides access to the documents deposited with it to anyone
willing and able to pay the applicable fees;
(vi) Charges reasonable fees; and
(vii) In general, is so organized and has the capacity to be able
to reasonably carry out the purposes of this section.
(3) An information repository must notify the Director of the
Commission's Division of Market Regulation of any material changes that
occur in the facts and circumstances of its application for such
designation; and
(4) In the event it is determined that an information repository no
longer satisfies all of the attributes set forth in paragraph (i)(2) of
this section, the Director of the Commission's Division of Market
Regulation may revoke such designation.
(j) The definitions applicable to this section. For purposes of
this section, the following definitions apply:
(1) Alternative trading system has the same meaning contained in
Sec. 242.300(a) of this chapter.
(2) Asset backed security has the meaning contained in General
Instruction I.B.5. to Form S-3 (17 CFR 239.13).
(3) Information repository means an entity that:
(i) Gathers and provides to brokers or dealers and others current
issuer information described in paragraph (c) of this section when this
information is not routinely or widely made available, electronically
or otherwise; and
(ii) Is designated by the Commission as an information repository
as described in paragraph (i) of this section.
(4) Issuer, in the case of quotations for American Depositary
Receipts, means the issuer of the deposited shares represented by such
American Depositary Receipts.
(5) NASD means the National Association of Securities Dealers,
Inc., and its wholly owned subsidiaries (including, but not limited to,
NASD Regulation, Inc. and The Nasdaq Stock Market, Inc.).
(6) Nasdaq means The Nasdaq National Market and The Nasdaq SmallCap
Market, both operated by The Nasdaq Stock Market, Inc.
(7) Net tangible assets means total assets less intangible assets
and liabilities. For purposes of this section, net tangible assets must
be demonstrated by current financial statements, as described in
paragraph (c)(6)(xiii) of this section, and:
(i) If the issuer is not a foreign private issuer, the financial
statements must be audited and reported on by an independent public
accountant in accordance with Sec. 210.2-02 of this chapter; or
(ii) If the issuer is a foreign private issuer, the financial
statements must be prepared in accordance with a comprehensive body of
accounting principles, audited in compliance with requirements of the
country of incorporation, and reported on by an accountant duly
registered and in good standing in accordance with the regulations of
that jurisdiction.
(8) Non-participatory preferred stock means non-convertible capital
stock, the holders of which are entitled to a preference in payment of
dividends and in distribution of assets on liquidation, dissolution, or
winding up of the issuer, but are not entitled to participate in
residual earnings or assets of the issuer.
(9) Promoter has the same meaning contained in Sec. 230.405 of this
chapter.
(10) Publish means to publish a quotation for a security in a
quotation medium or, directly or indirectly, to submit a quotation for
a security for publication in a quotation medium.
(11) Quotation means any bid or offer at a specified price with
respect to a security, or any indication of interest by a broker or
dealer in receiving bids or offers from others for a security, or any
indication by a broker or dealer that advertises its general interest
in buying or selling a particular security.
(12) Quotation medium means any:
(i) System of general circulation to brokers or dealers that
regularly disseminates quotations of identified brokers or dealers; or
(ii) Publication, alternative trading system, or other device that
is used by brokers or dealers to disseminate quotations to others.
(13) Securities Act means the Securities Act of 1933 (15 U.S.C. 77a
et seq.).
(k) How this section applies to securities for which a broker or
dealer is publishing quotations immediately before the effective date
of the amendments. If you were publishing a quotation for a security on
the business day immediately before April 7, 1999, you may continue to
publish quotations for the security without complying with paragraph
(b) of this section until you publish a quotation described in
paragraphs (a)(2), (a)(3), (a)(4), (a)(5), or (a)(6) of this section.
(l) The Commission can grant exemptions from this section. This
section does not prohibit the publication of any quotation for a
security or a class of securities, if the Commission, on written
request or its own motion, exempts such quotation, either
unconditionally or on specified terms and conditions.
3. Section 240.17a-4 is amended by adding paragraph (b)(11) to read
as follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(11) The records required to be obtained pursuant to Sec. 240.15c2-
11.
* * * * *
Dated: February 25, 1999.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Note: This Appendix to the Preamble will not appear in the Code
of Federal Regulations.
Appendix
Guidance on the Scope of a Broker-Dealer's Review Under Current Rule
15c2-11 and the Amendments
I. Introduction
To assist broker-dealers in complying with Rule 15c2-11 (Rule) \1\
under the Securities Exchange Act of 1934 (Exchange Act),\2\ we are
setting forth the factors that they should consider in carrying out
their review obligations
[[Page 11146]]
under the Rule as it currently exists and under the amendments proposed
in Securities Exchange Act Release No. 34-41110.\3\ We are providing
this guidance because commenters on the initial proposal \4\ expressed
concerns about their review obligations under its provisions,
particularly in light of elimination of the piggyback provision, the
addition of an annual review requirement, and the obligation to obtain
enhanced issuer information. This guidance applies, unless otherwise
noted, to a broker-dealer's obligations under the current Rule as well
as under the reproposal.
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\1\ 17 CFR 240.15c2-11.
\2\ 15 U.S.C. 78a et seq.
\3\ This appendix sets forth guidance on a broker-dealer's
review obligations under the Rule as it currently exists and under
the proposed amendments. If the Commission takes final action on the
proposed amendments, the Appendix will be revised to delete
references to the proposal and to reflect the final rule. We expect
that the Appendix will provide useful guidance to broker-dealers in
conducting the document review required by the Rule.
\4\ Securities Exchange Act Release No. 39670 (February 17,
1998), 63 FR 9661 (Proposing Release).
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Rule 15c2-11 regulates the publication of quotations for OTC
securities in a quotation medium.\5\ The Rule generally prohibits
broker-dealers from publishing a quotation unless they have reviewed
specified information about the issuer. The kind of information
depends on the nature of the issuer, e.g., whether the issuer is
subject to the Exchange Act's periodic reporting requirements
(reporting issuer) or is an issuer that is not subject to the
Exchange Act's reporting requirements (non-reporting issuer).
Broker-dealers must also have a reasonable basis for believing that
the issuer information, when considered in conjunction with any
supplemental information,\6\ is accurate in all material respects
and that it was obtained from a reliable source.
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\5\ A quotation is broadly defined as any indication that a
broker-dealer is willing to buy or sell a particular security. The
reproposed Rule, however, applies most directly to priced
quotations. Rule 15c2-11 applies to broker-dealers that publish
quotations for securities traded in the OTC markets. In this
appendix, ``OTC stocks'' or ``OTC securities'' refers to securities
that are not listed on a national securities exchange or Nasdaq.
``Covered OTC securities'' refers to those OTC securities that are
subject to Rule 15c2-11. Rule 15c2-11 applies to securities quoted
on the OTC Bulletin Board, operated by the National Association of
Securities Dealers, Inc. (NASD); the Pink Sheets operated by the
National Quotation Bureau, Inc. (NQB); and similar quotation
systems.
\6\ See footnote 14 below for a description of ``supplemental
information.''
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The Rule is precise about the kind of issuer and other
information that the broker-dealer must obtain and review before
publishing quotations and about how current that information must
be. However, some commenters on the Proposing Release stated that
they were unclear about the nature of the broker-dealer's obligation
to determine that the broker-dealer reasonably believes that the
source of the Rule 15c2-11 information is reliable and that the
information is accurate in all material respects. We are giving our
views on the steps a broker-dealer should take to assess the
reliability of the source of the required information and the
accuracy of that information.\7\
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\7\ This discussion confirms and supplements earlier guidance on
Rule 15c2-11 issues. See Securities Exchange Act Release No. 29094
(April 17, 1991), 56 FR 19148 (1991 Adopting Release); Securities
Exchange Act Release No. 27247 (September 14, 1989), 54 FR 39194
(1989 Proposing Release).
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II. Quotation Events Triggering the Review Requirement
Under the current Rule, the first broker-dealer to publish a
priced quotation must obtain and review the Rule's required
information. Under the current Rule's piggyback exception, a broker-
dealer does not have to satisfy these information requirements when
it publishes a quotation for a security if it, or any other broker-
dealer, is already publishing regular quotations for the
security.\8\ This means that the first market maker publishing a
quotation is the only one that has to obtain the required
information, and thereafter, any other market maker can publish
quotations in the security indefinitely, unless there is a
significant lapse in quotation activity.\9\
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\8\ 17 CFR 240.15c2-11(f)(3). The security must have been the
subject of quotations on at least 12 business days during the
previous 30 calendar days, with no more than 4 consecutive business
days elapsing without a quotation. Effectively, the Rule applies
only to those market makers publishing quotations during the first
30 days of a security's trading. The ability to piggyback on one's
own quotations is referred to as ``self-piggybacking.''
\9\ The piggyback exception would be eliminated under the
proposed amendments.
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The amendments will restructure Rule 15c2-11 by setting forth
more clearly the quotation events that trigger the Rule, the
requirements that the broker-dealer must satisfy, and the nature of
the information that the broker-dealer must review. The amendments
state that 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.\10\
Under the amendments, the Rule will apply at specified points in
time, namely, when a broker-dealer publishes:
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\10\ The current Rule applies to an interdealer quotation
system, which is a quotation medium of general circulation to
brokers or dealers which regularly disseminates quotations of
identified brokers or dealers. 17 CFR 240.15c2-11(e)(2). Under the
proposed amendments, the definition of ``interdealer quotation
system'' would be incorporated into the definition of ``quotation
medium.'' Under the amendments, a ``quotation medium'' will be a
system of general circulation to brokers or dealers that regularly
disseminates quotations of identified brokers or dealers; or
publication, alternative trading system, or other device that is
used by brokers or dealers to disseminate quotations to others.]
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the first quotation for a security;
its first quotation at a specified price for a security
after another broker or dealer published the first quotation for the
same security.
the first quotation following the termination of a
Commission trading suspension ordered pursuant to section 12(k) of
the Exchange Act \11\ in any security of the issuer of the suspended
security;
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\11\ 15 U.S.C. 78l(k).
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a quotation at a specified price for a security after a
period of five or more consecutive business days when it did not
publish any quotations at a specified price for that security;
its first quotation at a specified price for a security
after the date that is four months after the end of the issuer's
fiscal year, unless the issuer is a foreign private issuer; or
its first quotation at a specified price for a security of
a foreign private issuer after the date that is seven months after the
end of the issuer's fiscal year.
If the Rule applies, under both the current Rule and the
amendments, the broker-dealer must:
review the Rule's specified information;
determine that it has a reasonable basis for believing
that the information is accurate in all material respects and was
obtained from reliable sources;
Record the date it reviewed the specified information,
the sources of the information, and the person at the firm
responsible for the broker-dealer's compliance with the Rule; and
Preserve the specified information in accordance with
Rule 17a-4.\12\
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\12\ 17 CFR 240.17a-4.
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We set out below in more detail the review obligation required
of a broker-dealer before it publishes a quotation for covered OTC
securities. In general, the broker-dealer must first form a
reasonable belief about the source's reliability. Then the broker-
dealer should examine the materials to make sure it has obtained all
of the information required by the Rule, including any supplemental
information known by the broker-dealer. In reviewing this
information, the Rule requires that the broker-dealer must have a
reasonable basis under the circumstances for believing that the
issuer information described in paragraph (a) [reproposed paragraph
(c)] of the Rule,\13\ when considered in conjunction with the
supplemental information described in paragraph (b) [reproposed
paragraph (d)] of the Rule,\14\ is accurate in all material
[[Page 11147]]
respects and was obtained from reliable sources.
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\13\ Currently, a broker-dealer must review and maintain in its
records certain issuer information, which, depending on the issuer,
may include prospectuses or offering circulars; certain Exchange Act
reports; other regulatory filings; information furnished to the
Commission pursuant to Section 12(g)(2)(G)(i) of the Exchange Act;
or certain financial information for non-reporting issuers. The
amendments expand the information required for issuers that do not
file periodic reports with the Commission (e.g., non-reporting
issuers). In addition, broker-dealers would be required to make the
issuer information available to anyone who requested it.
\14\ In addition to a copy of any trading suspension order
issued by the Commission pursuant to Exchange Act Section 12(k), the
broker-dealer must record and consider any other material
information (including adverse information) regarding the issuer
that comes to its knowledge or possession before publishing a
quotation under the Rule. Paragraph (b) [reproposed paragraph (d)]
does not require a broker-dealer to maintain trivial information or
information from an uncertain source. Also, the broker-dealer is not
required to affirmatively seek out information about the issuer
beyond that specifically required by the Rule. However, if material
information about the issuer comes to its knowledge or possession
(orally or in writing), the broker-dealer must take that information
into account in assessing whether the issuer information is accurate
and is from a reliable source. See footnote 35 below regarding how
to obtain information about Commission trading suspensions.
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In addition, we are providing numerous examples of ``red flags''
often associated with Rule 15c2-11 documents. A red flag is
information that under the circumstances signals that one or more of
the required items of information may be materially inaccurate. We
consider these red flags to be indications that should lead a
broker-dealer to inquire whether it had a reasonable basis to
believe that the issuer information is accurate in all material
respects and that it was obtained from a reliable source.
The red flags that we discuss have been present in Commission
enforcement actions, examinations conducted by our staff, and
reviews of Rule 15c2-11 conducted by the National Association of
Securities Dealers, Inc. (NASD) submissions, but our discussion is
not meant to be exhaustive. Other information may come into the
broker-dealer's knowledge or possession that would lead it to
question whether the source is reliable or whether the required
information is accurate in all material respects. The adequacy of a
broker-dealer's review must be considered on a case-by-case basis.
The reproposed Rule would require a broker-dealer to obtain and
review some issuer information not required by the current Rule,
such as criminal or securities law violations and additional issuer
information. Until the proposal is adopted, the Rule does not
require the broker-dealer to obtain and review this information.
This information, however, would be a red flag and, under the
current Rule, could be ``material information'' that the broker-
dealer must take into account when conducting its review
obligations.
III. The Review Process
A. Introduction
While the broker-dealer must obtain and review the required
information, the standard of review is based on a broker-dealer's
arriving at a reasonable belief, not a certainty, that the
information is accurate and was obtained from a reliable source.
Although broker-dealers often refer to their Rule 15c2-11 files as
``due diligence'' files, the Rule's standard of review does not
approach the depth of inquiry generally associated with an
underwriter's obligations in a registered public offering or with a
retail broker's obligations in recommending a security to a
customer. As discussed below, the scope of review is relatively
simple in the case of an issuer that has just completed a public
offering or an offering under Regulation A \15\ or that files
periodic reports with the Commission.\16\ In these cases, the
broker-dealer must obtain and review information that is on file
with the Commission, in addition to any supplemental information. In
the case of a non-reporting issuer, where there may be no
information filed with a regulatory authority, the broker-dealer
must obtain the required information from sources its deems reliable
and must review this information together with any supplemental
information.
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\15\ 17 CFR 230.251-230.263.
\16\ Under the reproposal, the broker-dealer can look to filings
made with other federal or state regulatory authorities for certain
types of issuers, e.g., financial institutions.
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The Rule does not currently specify the status of the person who
must conduct the review on the broker-dealer's behalf. Under the
reproposed Rule, the broker-dealer must make a record of the person
at the firm who is responsible for the broker-dealer's compliance
with the Rule's provisions.\17\ Generally, the person performing the
review should have sufficient experience or authority at the firm to
make sure that the Rule's requirements are fully satisfied.
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\17\ See text of reproposed Rule 15c2-11(b)(3)(iv).
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Rule 15c2-11 is intended to prevent broker-dealers from becoming
involved in the fraudulent manipulation of OTC securities. However,
even if a broker-dealer technically complies with the Rule's
requirements, it would be subject to liability under other antifraud
provisions of the securities laws, such as Rule 10b-5, if a broker-
dealer publishes quotations as part of a fraudulent or manipulative
scheme.\18\
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\18\ 17 CFR 240.10b-5.
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B. Source Reliability
1. Determining Whether a Source is Reliable
The broker-dealer must first have a reasonable basis for
believing that Rule 15c2-11 information comes from a reliable
source. In general, this means that the information was derived from
the issuer. If the information is from the issuer or its officers
and directors, attorney, or accountant, the broker-dealer generally
can assume that the source is reliable, absent red flags to the
contrary.\19\ If the information is from EDGAR or another
governmental website or an independent retrieval service \20\ or
standard research sources \21\ or an information repository
contemplated under the reproposed Rule, the broker-dealer can
satisfy the Rule's requirement to have a reasonable basis for
believing that the source of the information is reliable. If the
broker-dealer receives the information from an independent and
objective source, such as a bank that is not a market maker in the
security, which represents that it has prepared the information or
received the information directly from the issuer, the broker-dealer
typically may rely on that representation as to the source. Because
broker-dealers frequently obtain the Rule 15c2-11 information from
these sources, the reliability of the information's source is not
often called into question.
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\19\ Because of recent microcap fraud cases involving promoters,
a broker-dealer should not presume a promoter is a reliable source
of issuer information. See SEC Charges 44 Stock Promoters in First
Internet Securities Fraud Sweep, Press Release 98-117 (October 28,
1998) available at <http://www.sec.gov/news/press/98-117.txt>.
\20\ Examples of an ``independent retrieval service'' would be
the SEC's Public Reference Room or a document retrieval service.
\21\ Examples of ``standard research sources'' include
publications such as Standard & Poor's Standard Corporation Manual
and Moody's Investors Service Manuals.
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Occasionally, the broker-dealer may obtain the Rule 15c2-11
information from sources not associated with the issuer, such as
another market maker.\22\ In this case, the requesting broker-dealer
should inquire about the original source of the information. The
broker-dealer providing the information must make a record of the
source of the issuer information and can supply this information to
the requesting broker-dealer.
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\22\ The proposed Rule will require a broker-dealer to provide
the information to another broker-dealer upon request.
---------------------------------------------------------------------------
When a red flag regarding the source's reliability exists, the
broker-dealer must inquire further to reasonably determine whether
the information's source is reliable. To satisfy the Rule's
requirements, the broker-dealer must ascertain the original source
of the information, especially when a broker-dealer is provided
information from another broker-dealer that encourages the
publication of quotations rather than responds to a request for
information.\23\ If the broker-dealer providing the information
refuses to substantiate that the information is from the issuer,
this refusal is a red flag that may indicate that the source is
unreliable. If the broker-dealer is told that the issuer has
prepared or approved the information, the broker-dealer may need to
verify that representation by directly contacting the issuer.
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\23\ See Bunker Securities, Inc., 48 S.E.C. 859 (1987), aff'd
without opinion, 833 F.2d 303 (3d Cir. 1987).
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2. Examples of Unreliable Sources
The Report of Investigation Regarding Transactions in the
Securities of Laser Arms Corporation (Laser Arms Report) illustrates
when a broker-dealer did not have a reasonable basis to believe that
the information about a non-reporting issuer was from a reliable
source.\24\ The Laser Arms Report noted that ``inherent in the
requirement of paragraph (a)(5) [reproposed paragraph (c)(6)] is 'the
premise that the broker-dealer must at least verify that it has
received the required information and know that source of the
information.'' \25\
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\24\ 50 S.E.C. 489 (1991). The Laser Arms Report was issued
pursuant to the investigative authority granted to the Commission
under Section 21(a) of the Exchange Act (15 U.S.C. 78u(a)).
\25\ Laser Arms Report at 501, citing Securities Exchange Act
Release No. 34-29095 (April 17, 1991), 56 FR 19158 (1991 Proposing
Release).
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The broker-dealer that submitted the initial application to quote
Laser Arms stock did not make any attempt to verify the source of the
issuer information contained in the Laser Arms Memorandum. In fact, it
was a fictitious document prepared by a recidivist securities law
violator who was the
[[Page 11148]]
undisclosed principal of Laser Arms.\26\ The broker-dealer's immediate
source of the Laser Arms Memorandum was a trader at another broker-
dealer whom he had known for less than one year, had seen on only a few
occasions, and had dealt with primarily by telephone. The broker-dealer
did not review or attempt to determine the source of any part of the
information in the Laser Arms Memorandum. Any attempt to contact the
issuer directly probably would have led to the discovery that Laser
Arms was a shell corporation with no assets, operations, or
products.\27\ Under these circumstances, the Commission did not believe
that this broker-dealer, or any of the broker-dealers to subsequently
publish quotations, had a reasonable basis for believing that the
source of the Rule 15c2-11 information was reliable.\28\
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\26\ The Laser Arms Memorandum misrepresented Laser Arms as a
high technology weapons manufacturer and the developer of a self-
chilling beverage can. The memorandum also included forged
certificates of incorporation, fictitious balance sheets, and
auditor's report which the signature of the accountant had been
forged.
\27\ Another broker-dealer who attempted to call Laser Arms
learned there was no telephone listing for the company. This broker-
dealer nevertheless initiated a market in Laser Arms' securities.
\28\ See also Bunker Securities, Inc., 48 S.E.C. 859 (1987,
aff'd without opinion, 833 F.2d 303 (3d Cir. 1987).
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C. Document Review Obligations
Once the broker-dealer has formed a reasonable belief about the
source's reliability, it should examine the materials to make sure it
has obtained all of the information required by the Rule. This means
that a broker-dealer must not only review the information about the
issuer of the security to be quoted but also consider any supplemental
information.\29\ The Rule requires that the broker-dealer must have a
reasonable basis under the circumstances for believing that the issuer
information described in paragraph (a) [reproposed paragraph (c)] of
the Rule, when considered in conjunction with the supplemental
information described in paragraph (b) [reproposed paragraph (d)] of
the Rule, is accurate in all material respects.
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\29\ See footnote 14 above for a definition of supplemental
information.
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Unlike the duties of an underwriter in a securities offering, Rule
15c2-11 ordinarily does not require a broker-dealer to conduct an
independent inquiry about the issuer of the security to be quoted. A
broker-dealer publishing quotes for a covered OTC security may have no
relationship with the issuer, and the Rule does not demand that the
broker-dealer develop one to obtain information. However, the broker-
dealer must review the required information, together with any
supplemental information that comes to its attention, and should be
alert to red flags.
Because documents filed with the Commission are subject to
liability provisions, a broker-dealer generally can reach a
reasonable belief as to the accuracy of information contained in
these documents.\30\ This also would be true for documents filed
with financial institutions' regulatory authorities, which broker-
dealers may obtain and review when publishing quotes for the
securities of certain banks, provided for in paragraph (c)(4) of the
reproposed Rule.
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\30\ See Sections 11 and 27 of the Securities Act, 15 U.S.C. 77k
and 77x, and Sections 18 and 32 of the Exchange Act, 15 U.S.C. 78r
and 78ff. See 1991 Adopting Release, 56 FR 19148, 19150 (1991).
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If a registration statement incorporates other documents by
reference, the broker-dealer may be required to obtain some of the
incorporated documents to satisfy the Rule's information gathering
and review requirements. It should not be necessary for the broker-
dealer to be familiar with all aspects of the filed documents. The
broker-dealer should focus on those sections that describe the items
of information set forth in Rule 15c2-11(a)(5) [reproposed Rule
15c2-11(c)(6)], the issuer's identified ``risk factors,'' \31\ any
recent material business combinations, such as the merger of a
reporting shell into a non-reporting company, and current financial
information.
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\31\ If the issuer's registration statement, pursuant to Item
401 of Regulation S-K, describes criminal or other disciplinary
proceedings involving a reporting issuer's officer, director,
general partner, promoter, or control person, this would be a red
flag. Reproposed Rule 15c2-11(c)(6)(xi) will require broker-dealers
to inquire about these types of criminal or other disciplinary
proceedings involving a non-reporting issuer's office, director,
general partner, promoter, or control person. Under the current
Rule, however, a broker-dealer's knowledge of criminal or other
disciplinary proceedings involving a reporting or non-reporting
issuer's officer, director, general partner, promoter, or control
person would be a red flag.
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In contrast to information from other kinds of issuers, non-
reporting issuer information generally has not been filed with any
regulatory authority. Thus, the broker-dealer cannot make any
assumptions about the accuracy of such information. Similarly, a
broker-dealer cannot make any assumptions about the accuracy of
information to documents and other materials that are submitted to
the Commission by foreign private issuers under Rule 12g3-2(b).
Although they are submitted to the Commission, these documents are
not ``filed'' and so are not subject to the liabilities that attach
to reporting issuer information. These documents are prepared in
accordance with the standards of the issuer's home jurisdiction, not
the standards set forth under the U.S. federal securities laws, and
broker-dealers should independently assess the accuracy of such
information. Broker-dealers will also need to independently assess
the accuracy of information filed with foreign securities regulatory
authorities, based on considerations such as the disclosure and
liability standards under foreign law. In reviewing the Rule's
required information for non-reporting issuers, the kinds of
significant events that require a domestic reporting issuer to file
a Form 8-K under the Exchange Act \32\ also should be considered red
flag events.
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\32\ 17 CFR 249.308.
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Where no red flags appear during the review of current and
complete information, the broker-dealer would have a reasonable
basis for believing that the Rule's information is accurate. At this
point, the broker-dealer's review ordinarily would end, i.e., the
broker-dealer would not be required to question the financial
statements or any other information required to be obtained and
reviewed. The Rule does not require the broker-dealer to question
any information unless the information contains apparent material
discrepancies, or other information in the broker-dealer's knowledge
or possession (i.e., paragraph (b) [reproposed paragraph (d)]
information) reasonably indicates that the paragraph (a) [reproposed
paragraph (c)] information is materially inaccurate.
When red flags are present, the broker-dealer's 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 broker-dealer is aware that the required issuer
information is materially inaccurate, it may nevertheless publish
quotations without violating the Rule, as long as the broker-dealer
can supplement that information with additional information that the
broker-dealer reasonably believes is accurate. 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 Rule's information from another source. For example, a broker-
dealer that is aware that the required issuer information is
inaccurate could produce a written record reflecting the additional,
corrected information or could obtain other materials, such as a
more recent Form 8-K,\33\ that would permit the broker-dealer to
comply with the Rule. If the broker-dealer sees that the auditor's
report in an issuer's financial statements is qualified, the broker-
dealer may need to contact the accountants about the basis for such
qualification. If the broker-dealer learns that an issuer's control
person has been convicted of securities fraud, it should contact the
appropriate regulatory authority to ascertain the facts.\34\
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\33\ 27 CFR 249.308.
\34\ Even thought he criminal and securities law violations
specified in reproposed paragraph (c)(6)(xi) are not specified in
paragraph (a)(5) of the current Rule, a broker-dealer's knowledge of
such information would be material adverse information under the
current rule, and such violations would be a red flag.
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The Rule's provisions are triggered by discrete quotation
events. Once the broker-dealer has complied with the Rule's
requirements with respect to a particular quotation event, there is
no continuing duty to obtain and review the information. Of course,
when a quotation event occurs, e.g., the broker-dealer is publishing
priced quotations as of the annual review date
[[Page 11149]]
required by the reproposed Rule, it must conduct a review of current
issuer information. In this case, the review process would be the
same as described above. However, the review process should be
somewhat simpler because the broker-dealer would already have gained
some familiarity with the issuer as a result of its prior review.
D. Scope of Review Following a Trading Suspension
A Commission trading suspension is a material event affecting
the market for an issuer's securities.\35\ After the termination of
a trading suspension, a broker-dealer may not enter a quotation
unless and until it has strictly complied with all the provisions of
the Rule. Before initiating or resuming a quotation for securities
subject to Rule 15c2-11, the broker-dealer must conduct a careful
review in a professional manner of the basis for the trading
suspension to determine whether there is a reasonable basis for the
broker-dealer to believe that the information about the issuer is
accurate and current. The broker-dealer may be unable to reach a
reasonable basis for relying on the questioned financial statements
in the Commission's order even if the information otherwise
satisfies the Rule's presumption of ``current'' information.\36\
This presumption is obviated if the broker-dealer has information to
the contrary.\37\
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\35\ See Section 12(k) of the Exchange Act. Information
regarding recent trading suspension orders can be obtained by
calling 800-SEC-0330. The broker-dealer must obtain a copy of the
trading suspension order or a copy of the Commission release
announcing the trading suspension. Copies of Commission releases may
be obtained through our Internet website at <http://www.sec.gov/
enforce/tsuspend.htm> or from the Commission's Public Reference Room
in Washington, D.C. and in regional Commission offices. Also,
Commission releases are available form information databases (e.g.,
LEXIS), and also are published in the SEC Docket, which is available
from publication services (e.g., Commerce Clearing House, Inc.).
\36\ The reproposal contains a presumption that the financial
information of both reporting issuers and domestic and foreign non-
reporting issuers is current if it is less than 15 months old.
However, if the broker-dealer has other information that indicates
that the issuer's financial condition has materially changed from
that shown in the financial statements, this presumption may not
apply, and the broker-dealer should determine whether more recent
financial information is available. Financial information older than
15 months is not current and does not satisfy the Rule's
requirements.
\37\ General Bond & Share Co., 51 S.E.C. 411 (1993) (Commission
opinion), rev'd on other grounds, General Bond & Share Co. v. SEC,
39 F.3d 1451 (10th Cir. 1994); See also Robin Rushing and Harold
Gallison, Jr., Securities Exchange Act Release No. 36910 (February
29, 1996).
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The broker-dealer must also check the reliability of the source
of the information, particularly when the same source is providing
updated information. If the broker-dealer seeks assurances or
additional information from the source (in most cases, the issuer)
about the matters cited in the Commission trading suspension order,
great caution should be used before relying on the statements or
assurances from the issuer. The broker-dealer may have to test the
accuracy of the information or the source's reliability by
conducting an independent review or obtaining verification of
information provided by the issuer. The broker-dealer may need to
seek an opinion of an independent accountant or attorney to form a
reasonable basis to believe that the Rule's information is accurate
and from a reliable source. In one enforcement action, a broker-
dealer unreasonably relied on pre-suspension financial statements
when the Commission's trading suspension was based upon a lack of
accurate financial information and the issuer's auditors indicated
to the broker-dealer that they were having problems verifying the
issuer's financial information.\38\
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\38\ Robin Rushing and Harold Gallison, Jr., Securities Exchange
Act Release No. 36910 (February 29, 1996); see also Bagle
Securities, Inc., Securities Exchange Act Release No. 27673
(February 5, 1990); William V. Frankel & Company, Securities
Exchange Act Release No. 27649 (January 26, 1990); Richfield
Securities, Inc., Securities Exchange Act Release No. 26129
(September 29, 1988).
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A broker-dealer may have difficulty obtaining the necessary
information about an issuer after the expiration of a trading
suspension. This difficulty, however, does not relieve the broker-
dealer of its responsibilities under the Rule. If any broker-dealer
is uncertain as to what is required by the Rule, it should refrain
from entering quotations relating to the securities in question
until the Rule's provisions have been met.
IV. Examples of Red Flags
If the broker-dealer discovers at any stage of the review
process any red flags in the issuer information (whether the issuer
is a reporting or non-reporting company), it cannot publish a quote
unless and until those red flags are reasonably addressed. Material
inconsistencies in the paragraph (a) [reproposed paragraph (c)]
information, or material inconsistencies between that information
and the paragraph (b) [reproposed paragraph (d)] information, are
red flags. We have set out below examples of red flags that we have
noticed in microcap fraud cases or in Rule 15c2-11 submissions made
to the NASD. These examples, however, are not comprehensive, as red
flags depend on the facts and circumstances of each case.
We are providing examples of red flags that require additional
scrutiny by the broker-dealer to comply with Rule 15c2-11. These
examples, however, are not exhaustive. Conversely, the presence of
these or other red flags is not necessarily an indication of
microcap fraud or even inaccurate issuer information. The red flag
simply means that the broker-dealer should question whether the
issuer information is accurate, and in certain cases, from a
reliable source. The more red flags that are present, the more a
broker-dealer should scrutinize the issuer information.
1. Commission Trading Suspensions. As indicated above,
Commission trading suspension orders generally raise significant red
flags as to whether the Rule 15c2-11 information is accurate and
whether its source is reliable. Broker-dealers publishing quotes
once a trading suspension terminates must satisfy the Rule's
requirements, which may include seeking verification from the issuer
or soliciting the views of an independent professional.
2. Foreign Trading Suspensions. A trading suspension by a
foreign regulator may indicate that the issuer information is
unreliable or inaccurate. However, a trading suspension in a foreign
market may be imposed simply because the issuer failed to meet
exchange listing standards. If the broker-dealer learns of a foreign
trading suspension, it should attempt to determine the basis for the
suspension order and assess whether the issuer information is still
accurate and whether its source is still reliable.
3. Concentration of ownership of the majority of outstanding,
freely tradeable stock. Concentration of ownership of freely
tradeable securities is a prominent feature of microcap fraud cases.
When one person or group controls the flow of freely tradeable
securities, this person or persons can have a much greater ability
to manipulate the stock's price than when the securities are widely
held. In a ``pump and dump'' scheme, retail interest is stimulated,
and the price of the securities is manipulated upward, at the behest
or under the control of the manipulators who control much of the
stock. Often, other broker-dealers that are not intentionally
participating in improper activities publish quotations in response
to escalating demand for the security resulting from increasing
retail sales. The promoters of these companies, company insiders,
and unscrupulous brokers make substantial profits when they sell
their shares at inflated prices. When the scheme is over, the
security's price plummets, and innocent investors who paid a premium
price are left holding worthless shares.\39\
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\39\ See New Allied Development Corporation, Securities Exchange
Act Release No. 37990 (November 26, 1996)(New Allied's control
persons had substantial stock interest in nominee accounts);
Douglass and Co., Inc., 46 S.E.C. 1189 (1978); Gotham Securities
Corporation, 46 S.E.C. 723 (1976). Paragraph (c)(6)(x) of the
reproposed Rule will require disclosure of the beneficial ownership
of the issuer's stock by its executive officers, directors, general
partners, promoters, or control persons.
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4. Large reverse stock splits. Microcap fraud schemes can
involve the substantial concentration of the publicly-traded float
through a reverse stock split. The subsequent issuance of large
amounts of stock to insiders increases their control over both the
issuer and trading of the stock.\40\
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\40\ Emshwiller, ``Reverse Stock Splits At Many Firms Spark
Outcry.'' The Wall Street Journal, November 20, 1998, at Cl; SEC v.
Magna Technologies, Inc., Litigation Release No. 12227 (August 21,
1989) (insiders of Magna effected a 4-for-1 reverse stock split,
concentrated ownership in themselves, and then manipulated the price
of Magna's stock by disseminating false and misleading information).
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5. Companies in which assets are large and revenue is minimal
without any explanation. A red flag exists when the issuer assigns a
high value on its financial statements to
[[Page 11150]]
certain assets that are often unrelated to the company's business
and were recently acquired in a non-cash transaction. In this
situation, the company's revenues often are minimal and there
appears to be no valid explanation for such large assets and minimal
revenues.\41\
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\41\ New Allied Development Corporation, Securities Exchange Act
Release No. 37990 (November 26, 1996).
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Also, a red flag is present when the financial statements of a
development stage issuer list as the principal component of the
issuer's net worth an asset wholly unrelated to the issuer's line of
business. For example, from a review of Rule 15c2-11 submissions,
art collections or other collectibles that are unrelated to the
issuer's business apparently have been overvalued on the financial
statements of some issuers.\42\ While assets that are unrelated to
the business of the issuer are not always an indication of potential
microcap fraud, some unscrupulous issuers have overvalued these
types of assets in an effort to inflate their balance sheets.
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\42\ See In the Matter of Rom N. De Guzman, Securities Exchange
Act Release No. 37747 (September 30, 1996).
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6. Shell corporation's acquisition of private company. A shell
corporation is characterized by no business operations and little or
no assets. In a fraud scheme, a reporting company with a large
number of shares controlled by one person or a small number of
persons often merges with a non-reporting company having some
business operations. The new public company is then used as the
vehicle for ``pump and dump'' and other fraudulent schemes. Broker-
dealers placing quotes for these issuers' securities should be
mindful of the potential for abuse.\43\
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\43\ See New Allied Development Corporation, Securities Exchange
Act Release No. 37990 (November 26, 1996); Stylex Homes, Inc.,
Securities Exchange Act Release No. 36299 (September 29, 1995);
Bunker Securities, Inc., 48 S.E.C. 859 (1987), aff'd without
opinion, 833 F. 2d 303 (3d Cir. 1987); Butcher & Singer, Inc., 48
S.E.C,. 640, aff'd without opinion, 833 F. 2d 303 (ed Cir. 1987);
Douglass and Co., Inc., 46 S.E.C. 1189 (1978); A.J. Carno Co., 1976
SEC LEXIS 2764 (February 23, 1976) (initial decision), order
dismissing proceeding and withdrawing broker-dealer registration,
Securities Exchange Act Release No. 14647 (April 10, 1978); Gotham
Securities Corporation, 46 S.E.C. 723 (1976).
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7. Offerings under Rule 504 of Regulation D where one or more of
the following factors are present:
Little capital is raised in the Rule 504 offering and
there appears to be no business purpose except to provide some
shareholders with free-trading shares;
The Rule 504 offering is preceded by an unregistered
offering to insiders or others for services rendered at prices well
below the price in the subsequent offering;
Sales immediately following the Rule 504 offering are
at substantially higher prices than those paid in the Rule 504
offering; or
A shell company and an operating company merge, which
results in the operating entity becoming the surviving entity. The
surviving entity goes ``public'' by issuing shares pursuant to Rule
504.\44\
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\44\ See example 6, above.
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Rule 504 of Regulation D allows non-reporting companies to raise
up to $1 million per year in ``seed capital'' without complying with
Securities Act registration requirements. The freely tradable nature
of securities issued in Rule 504 offerings has facilitated a number
of fraudulent schemes through the OTC Bulletin Board Display Service
(OTC Bulletin Board) or the Pink Sheets published by the National
Quotation Bureau, Inc. (NQB).\45\ Broker-dealers should be alert to
information in the Rule 15c2-11 materials where an active trading
market is being promoted for securities issued solely in a Rule 504
transaction.
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\45\ See Securities Act Release No. 33-7644 (February 19, 1999)
in which we adopted amendments to Rule 504 of Regulation D that
limit the circumstances where general solicitation is permitted and
``freely tradeable'' securities may be issued in reliance on Rule
504 to transactions (1) registered under state law requiring public
filing and delivery of a disclosure document to investors before
sale, or (2) exempted under state law permitting general
solicitation and general advertising so long as sales are made only
to ``accredited investors.''
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8. A registered or unregistered offering raises proceeds that
are used to repay a bridge loan made or arranged by the underwriter
where:
The bridge loan was made at a high interest rate for a
short period;
The underwriter received securities at below-market
rates prior to the offering; and
The issuer has no apparent business purpose for the
bridge loan.
Broker-dealers have given small issuers bridge loans at a high
interest rate for a short time period.\46\ In exchange for this
bridge loan, the broker-dealer receives a significant number of
shares of the issuer's common stock at a price that is substantially
below market rates. The broker-dealer then engages in a scheme to
manipulate the stock's price and ultimately benefits when it dumps
the stock at an artificially high price.\47\
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\46\ Emshwiller, ``NASD Quietly Takes Aim at IPO Bridge-Loan
Trend,'' The Wall Street Journal, January 20, 1998, at Cl.
\47\ See Memory Metals, Inc., Securities Act Release No. 6820
(February 22, 1989).
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9. Significant write-up of assets upon a company obtaining a
patent or trademark for a product. The significant write-up of
assets upon the issuer's obtaining a patent or trademark for a
product is a technique used by issuers engaged in microcap fraud to
inflate their balance sheets.\48\
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\48\ New Allied Development corporation, Securities Exchange Act
Release No. 37990 (November 26, 1996); see also Frederick R. Grant,
Securities Exchange Release No. 38239 (February 5, 1997); Atlantis
Group, Inc., securities Exchange Act Release No. 37932 (November 8,
1996); Eli Buchalter, Securities Exchange Act Release No. 37702
(September 19, 1996); Milton Mermelstein, Securities Exchange Act
Release No. 37222 (May 16, 1996).
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10. Significant asset consists of OTC Bulletin Board or Pink
Sheet companies. We have noticed that some microcap fraud schemes
involve issuers whose major assets are substantial amounts of shares
in other OTC Bulletin Board or Pink Sheet companies.
11. Assets acquired for shares of stock when the stock has no
market value. In microcap fraud cases, the issuer's financial
statements often indicate that the issuer acquired assets to which
it assigned substantial value in exchange for its essentially
worthless stock.\49\
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\49\ See New Allied Development Corporation, Securities Exchange
Act Release No. 37990 (November 26, 1996) (the respondents obtained
new Allied, a public shell, which was a dormant uranium mining
company with no assets, in a transaction which resulted in insiders
controlling 52.4% of New Allied's stock; New Allied then acquired an
interest in real estate associated with worthless gambling concerns
in exchange for New Allied stock); Douglass and Co., Inc., 46 S.E.C.
1189 (1978).
---------------------------------------------------------------------------
12. Significant write-up of assets in a business combination of
entities under common control.
Those persons engaged in microcap fraud often use a business
combination such as a merger as an opportunity to falsify financial
statements.\50\ We have seen microcap fraud schemes in which
unscrupulous issuers use purchase method accounting \51\ to write up
the historical value of an asset to an artificially high value in
situations when the entities involved in the business combination
are under common control or otherwise have a high degree of common
ownership. For example, Generally Accepted Accounting Principles
(GAAP) requires that the acquisition of one entity by another entity
be accounted for at historical cost in a manner similar to that in
``pooling of interests'' accounting when these entities are under
common control.\52\
---------------------------------------------------------------------------
\50\ See New Allied Development corporation, Securities Exchange
Act Release No. 37990 (November 26, 1996) (the respondents
disseminated materially false documents to market makers, including
unaudit financial statements, that valued new Allied's medical and
consumer products at $2,150,000 although their historical costs were
approximately $17,000); A.J. Carno Co., 1976 SEC LEXIS 2764
(February 23, 1976) (Initial Decision), order dismissing proceeding
and withdrawing broker-dealer registration, Securities Exchange Act
Release No. 14647 (April 10, 1978) (Management Dynamics, Inc.'s (MD)
founding officer and director wrote MD shareholders to recommend the
acquisition of the assets of a real estate developer. Press releases
and shareholder letters reinforced the misleading impression that
the transaction was certain to generate substantial income for MD).
\51\ When two companies merge, compliance with Generally
Accepted Accounting Principles requires that the combination be
accounted for as either the ``pooling method'' or ``purchase
method.'' With the pooing method, the historical costs of the two
companies are added together. With purchase method accounting, the
company being acquired writes up its assets to fair market value,
which generally are greater than the historical costs.
\52\ Ronald Effren, Securities Act Release No. 7256, Securities
Exchange Act Release No. 36713 (January 16, 1996); see also Martin
Halpern, Securities Exchange Act Release No. 34727 (September 27,
1994).
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13. Unusual auditing issues.
Auditors refuse to certify financial statements or they
issue a qualified opinion; or
There has been a change of accountants.\53\
---------------------------------------------------------------------------
\53\ See Securities Exchange Act Form 8-K, Item 4; Merle S.
Finkel, Securities Act Release No. 7401 (March 12, 1997) (original
auditors notified systems of Excellence that purported registration
statement on Form S-8 had not been filed and that other
irregularities exist in connection with issuance of this stock;
thereafter, Systems of Excellence retained new auditor who issued
materially false or inaccurate audit reports.
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[[Page 11151]]
Rule 15c2-11 does not contemplate that the broker-dealer
scrutinize the issuer's financial statements with the expertise of
an accountant. The above red flags, however, do not require an
expertise in accounting matters and have appeared in several
microcap fraud schemes. In one case, the respondents stated in the
Form 211 submissions to the NASD that they relied on audited
financial statements. However, the auditors orally advised the
associated persons of the broker-dealer before they submitted the
Form 211 that the auditor's opinion attached to the pro forma
financial statement was qualified because of the auditor's inability
to verify the issuer's financial information.\54\
---------------------------------------------------------------------------
\54\ See Robin Rushing and Harold Gallison, Jr., Securities
Exchange Act Release No. 36910 (February 29, 1996). In this case,
the SEC also had entered a trading suspension for lack of accurate
financial information.
---------------------------------------------------------------------------
An accountant's resignation or dismissal is a characteristic
found in some microcap fraud cases. If a broker-dealer sees any of
these red flags, it should confirm the auditor's credentials with
the appropriate state licensing authority, question the
circumstances of the change in accountants, and carefully scrutinize
the Rule's required information.
14. Extraordinary items in notes to the financial statements,
e.g., unusual related party transactions. Unusual related party
transactions are sometimes found in microcap fraud schemes. For
example, an issuer's financial statements may show a related party
transaction between two companies, which later merge and inflate the
worth of their assets by using purchase method accounting.\55\
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\55\ See Ronald Effren, Securities Exchange Act Release No.
36713 (January 16, 1996).
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15. Suspicious documents.
Inconsistent financial statements;
Altered financial statements; or
Altered certificates of incorporation.
Altered or facially inconsistent issuer documents have been
present in various microcap fraud schemes. For example, Polaris
Mining Co. was a shell corporation with no meaningful assets and no
trading market for its stock.\56\ Douglass and Co., Inc., a broker-
dealer, published quotations for Polaris in the Pink Sheets in
violation of Rule 15c2-11 because the Polaris financial information
upon which Douglass and Co., Inc. relied was deficient and
contradictory on its face: two balance sheets for the same years
contained blatant disparities. Both balance sheets valued certain
mined but unprocessed ores at the estimated eventual selling price
even though significant processing work remained to be done. One
statement did not list property location. One statement had an item
for capitalized expenses and the other statement for the same year
did not. The former statement showed no retained earnings or
accumulated deficit, suggesting that the figure for capitalized
expenses was an arbitrary one designed to make assets and
liabilities balance out.\57\
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\56\ Douglass and Co., Inc., 46 S.E.C. 1189 (1978).
\57\ See also Butcher & Singer, Inc., 48 S.E.C. 640, aff'd
without opinion, 833 F.2d 303 (3d Cir. 1987) (a salesman and later
an officer of Butcher & Singer apparently obtained some blank stock
certificates and forged former officers' signatures as well as the
certificates' amounts and purported dates of issuance to himself and
his family members; the broker-dealer, Butcher & Singer, failed to
review the Rule's required information; Butcher & Singer might have
noticed red flags that would have led to the discovery of the
underlying fraud if it had reviewed the Rule's required
information).
---------------------------------------------------------------------------
In addition, issuer information that is altered on its face
raises red flags that, at a minimum, require the broker-dealer to
contact the issuer.\58\
---------------------------------------------------------------------------
\5\ See United States v. Marshall Zolp, Litigation Release Nos.
11494 (July 23, 1987) and 11236 (October 2, 1986)(fictitious
certificates of incorporation and fictitious financial statements on
which the name of another company had been whited out and the name
of Laser Arms filled in).
---------------------------------------------------------------------------
16. Broker-dealer receives substantially similar offering
documents from different issuers with the following characteristics:
The same attorney is involved;
The same officers and directors are listed; and/or
The same shareholders are listed.
It is not uncommon for the same individuals to be involved in
multiple microcap frauds. If a broker-dealer realizes after
reviewing the information for several issuers that the same
individuals are involved with these entities, the broker-dealer
should make further inquiries to determine whether it has a
reasonable basis to believe that the issuer information is accurate.
17. Extraordinary gains in year-to-year operations. In microcap
fraud cases, the issuer may show extraordinary gains in its year-to-
year operations. This may be accomplished through assigning an
artificially high value to certain assets or through other
manipulative devices that are red flags, such as the significant
write-up of assets upon merger or acquisition.\59\
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\59\ See, e.g., A. J. Carno Co., 1976 SEC LEXIS 2764 (February
23, 1976)(Initial Decision), order dismissing proceedings and
withdrawing broker-dealer registration, Securities Exchange Act
Release No. 14647 (April 10, 1978).
---------------------------------------------------------------------------
18. Reporting company fails to file an annual report. The fact
that a reporting company has not filed an annual report suggests
that there is a potential problem with the company.\60\
---------------------------------------------------------------------------
\60\ See Combined Companies International Corp., Securities
Exchange Act Release No. 38653 (May 19, 1997); Robin Rushing and
Harold Gallison, Jr., Securities Exchange Act Release No. 36910
(February 29, 1996).
---------------------------------------------------------------------------
19. Disciplinary actions against an issuer's officers,
directors, general partners, promoters, or control persons.
The following types of disciplinary actions should trigger
further investigation by a broker-dealer:
Indictment or conviction in a criminal proceeding; \61\
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\61\ Stylex Homes, Inc., Securities Exchange Act Release No.
36299 (September 29, 1995).
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Order permanently or temporarily enjoining, barring,
suspending or otherwise limiting an officer, director, general
partner, promoter, or control person's involvement in any type of
business, securities, commodities, or banking activities;
Adjudication by civil court of competent jurisdiction,
the Commission, the Commodity Futures Trading Commission or a state
securities regulator to have violated federal or state securities or
commodities law; or
Order by a self-regulatory organization permanently or
temporarily barring, suspending or otherwise limiting involvement in
any type of business or securities activities.\62\
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\62\ The reproposed text of Rule 15c2-11(c)(6)(xi)(A)(2)
requires the broker-dealer to review these factors for non-reporting
issuers. Otherwise, under the reproposed text of Rule 15c2-
11(c)(6)(xi)(B) or (C), the broker-dealer must obtain a statement
from the issuer that none of these events has occurred or must
record the steps taken to obtain this information and that the
issuer refused or failed to provide it. Even though the current Rule
does not require the broker-dealer to obtain and review this
information, we consider such information to be red flags under the
Rule if it comes to the broker-dealer's attention.
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Many microcap fraud cases involve recidivist securities law
violators.\63\ If a broker-dealer has information or could
reasonably discover information about the above types of violations,
it should question whether it has a reasonable basis to believe that
the issuer's information is accurate and complete in these
circumstances.
---------------------------------------------------------------------------
\63\ See SEC v. I-Net Providers, Litigation Release No. 15219
(January 17, 1997); New Allied Development Corporation, Securities
Exchange Act Release No. 37990 (November 26, 1996).
---------------------------------------------------------------------------
20. Significant events involving an issuer or its predecessor,
or any of its majority owned subsidiaries.
The following types of significant events should prompt further
investigation by a broker-dealer:
Change in control of the issuer; \64\
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\64\ See Exchange Act Form 8-K, Item 1.
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Substantial increase in equity securities;
Merger, acquisition, or business combination;
Acquisition or disposition of significant assets; \65\
---------------------------------------------------------------------------
\65\ See Exchange Act Form 8-K, Item 2.
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Bankruptcy proceedings; \66\ or
---------------------------------------------------------------------------
\66\ See Exchange Act Form 8-K, Item 3.
---------------------------------------------------------------------------
Delisting from any securities exchange or the Nasdaq Stock
Market.\67\
---------------------------------------------------------------------------
\67\ The proposed text of Rule 15c2-11(c)(6)(xii)(A) requires
the broker-dealer to review these factors. Otherwise, under the
proposed text of Rule 15c2-11(c)(6)(xii)(B) or (C), the broker-
dealer must obtain a statement from the issuer that none of these
events has occurred or must record the steps taken to obtain this
information and that the issuer refused or failed to provide it.
Even though the current Rule does not require the broker-dealer to
obtain and review this information, we consider such information to
be red flags under the Rule if it comes to the broker-dealer's
attention.
---------------------------------------------------------------------------
While not necessarily problematic, these are material events
involving the issuer. The change in control of the issuer, merger,
acquisition, or business combination, acquisition or disposition of
significant assets can provide unscrupulous issuers an opportunity
to artificially overvalue the issuer's assets to support an upward
manipulation of the issuer's worthless
[[Page 11152]]
stock.\68\ An increase in the issuer's equity securities provides
the securities necessary for such manipulation. Bankruptcy
proceedings or a delisting from an exchange or the Nasdaq Stock
Market may also indicate problems with an issuer that could lead the
broker-dealer to conclude that it does not have a reasonable basis
to believe that the issuer's financial information is accurate.\69\
---------------------------------------------------------------------------
\68\ See New Allied Development Corporation, Securities Exchange
Act Release No. 37990 (November 26, 1996); A. J. Carno Co., 1976 SEC
LEXIS 2764 (February 23, 1976)(Initial Decision), order dismissing
proceedings and withdrawing broker-dealer registration, Securities
Exchange Act Release No. 14647 (April 10, 1978); see also Bion
Environmental Technologies, Inc., Securities Exchange Act Release
No. 36111 (August 16, 1995).
\69\ See B.J. Thomas, Securities Exchange Act Release No. 38727
(June 10, 1997); SEC v. Magna Technologies, Inc., Litigation Release
No. 12227 (August 21, 1989); see e.g., Milton Mermelstein,
Securities Exchange Act Release No. 37222 (May 16, 1996).
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21. Request to publish both bid and ask quotes on behalf of a
customer for the same stock. The highly unusual request from a
customer for the broker-dealer to publish both bid and ask quotes is
a red flag ``that calls for appropriate inquiry on [the broker-
dealer's] part.'' \70\
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\70\ Alessandrini & Co., Inc., 45 S.E.C. 399 (1971), citing D.H.
Blair & Co., 44 S.E.C. 320 (1970).
---------------------------------------------------------------------------
22. Issuer or promoter offers to pay a ``due diligence'' fee. If
a market maker receives an offer from an issuer to pay a ``due
diligence'' fee in connection with making a market in the issuer's
security, this is not solely a red flag.\71\ It is a violation of
NASD Rule 2460 for the broker-dealer to accept this offer.\72\ If
the broker-dealer receives any consideration in connection with
publishing a quotation, the reproposed Rule requires the broker-
dealer to disclose any such compensation, as well as any other
significant relationship information between the issuer and the
broker-dealer publishing the quotation or any of its associated
persons.\73\ In Douglass and Co., Inc., a registered representative
said he would try to get the broker-dealer to initiate a market in
the stock of Polaris Mining Co., but that it would cost the issuer
about $1,500 to cover ``expenses.'' The registered representative
later agreed to accept Polaris stock (some of which he kept himself)
instead of the $1,500.\74\
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\71\ Butcher & Singer, Inc., 48 SEC 640, aff'd without opinion,
833 F.2d 303 (3d Cir. 1987)(a salesman received 400,000 shares of an
obscure penny stock for helping to develop and maintain a market in
the stock); see Brent Duane Green, Securities Exchange Act Release
No. 39210 (October 7, 1997); Steven Ira Wertman, Securities Exchange
Act Release No. 38751 (June 20, 1997); Christopher D. Jennings,
Securities Exchange Act Release No. 38696 (May 30, 1997).
\72\ NASD Rule 2460, Payments for Market Making, prohibits any
payment by an issuer or the issuer's affiliates and promoters,
directly or indirectly, to a member for publishing a quotation,
acting as a market maker, or submitting an application.
\73\ See reproposed Rule 15c2-11(e); see also current Rule 15c2-
11(a)(5)(xvi).
\74\ Douglass and Co., Inc., 46 S.E.C. 1189 (1978); see also See
Robin Rushing and Harold Gallison, Jr., Securities Exchange Act
Release No. 36910 (February 29, 1996); General Bond & Share Co., 51
S.E.C. 411 (1993)(Commission opinion), rev'd on other grounds,
General Bond & Share Co. v. SEC, 39 F.3d 1451 (10th Cir. 1994).
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23. Regulation S transactions of domestic issuers. Regulation S
\75\ provides a safe harbor from the registration requirements of
the Securities Act of 1933 for offers and sales of securities by
both foreign and domestic issuers that are made outside the United
States. We recently adopted amendments to Regulation S that are
designed to prevent the abuses that relate to offshore offerings of
equity securities of domestic issuers.\76\ Prior to the recent
amendments, Regulation S transactions involving large amounts of the
securities of U.S. issuers were particularly vulnerable to fraud and
manipulation.\77\ The perpetrators of the fraud sold the securities
to U.S. investors after the 40-day holding period expired, and
little information was available to investors about the issuers.
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\75\ 17 CFR 230.901-230.905 and Preliminary Notes.
\76\ Securities Act Release No. 7505 (February 17, 1998), 63 FR
9632. We also adopted amendments that would affect applicable
reporting requirements along with other amendments intended to
prevent abuses of Regulation S. Since January 1, 1999, Regulation S
transactions are required to be reported quarterly on Forms 10-Q and
10-K.
\77\ See Frederick R. Grant, Securities Exchange Release No.
38239 (February 5, 1997); S.E.C. v. Enviromint Holdings, Inc.,
Litigation Release No. 14683 (October 6, 1995).
---------------------------------------------------------------------------
Under the amendments, equity securities of U.S. issuers that are
sold offshore under Regulation S are classified as ``restricted
securities'' within the meaning of Rule 144 under the Securities
Act, and the period during which these securities cannot be
distributed in the United States is lengthened from 40 days to one
year. These amendments make Regulation S abuses less likely, but
broker-dealers should be alert to any questionable activities once
the one-year holding period expires.
24. Form S-8 stock. Form S-8 is the short-form registration
statement for offers and sales of a company's securities to its
employees, including consultants and advisors.\78\ The form has been
abused by unscrupulous issuers to register on Form S-8 securities
nominally offered and sold to employees or, more commonly, to so-
called consultants and advisors. These persons then resell the
securities in the public markets, at the direction of the issuer or
a promoter.\79\ In a typical pattern, an issuer registers on Form S-
8 securities underlying options issued to so-called consultants
where, by prearrangement, the issuer directs the consultants'
exercise of the options and resale of the underlying securities in
the public market. The consultants then either remit to the issuer
the proceeds from the sale of the underlying shares, or apply the
proceeds to pay debts of the issuer that are not related to any
services provided by the consultants.\80\ In some cases, these
consultants perform little or no other service for the issuer. In
other microcap frauds, the issuer uses Form S-8 to sell securities
to ``employees'' who act as conduits by selling the securities to
the public and remitting the proceeds (or their economic benefit) to
the issuer.\81\ This public sale of securities by the issuer has not
been registered, although the Securities Act requires registration.
The failure to register this sale of securities deprives public
investors of the protections afforded by the Securities Act.
---------------------------------------------------------------------------
\78\ Form S-8 under the Securities Act of 1933 (15 U.S.C. 77a et
seq.).
\79\ See S.E.C. v. Enviromint Holdings, Inc., Litigation Release
No. 14683 (October 6, 1995).
\80\ See, e.g., Spectrum Information Technologies, Inc.,
Securities Act Release No. 7426 (June 25, 1997); SEC v. Hollywood
Trenz, Inc., Litigation Release No. 15730.
\81\ See S.E.C. v. Charles O. Huttoe, Litigation Release Nos.
15153 (November 7, 1996); 15185 (December 12, 1996)(unregistered
public offering purporting to use Form S-8).
---------------------------------------------------------------------------
To prevent these abuses, Form S-8 and related rules impose
certain restrictions on the use of the form for the sale of
securities to certain consultants and advisors.\82\ We are also
proposing additional amendments to Form S-8.\83\ Although these
amendments should deter microcap abuses, broker-dealers nevertheless
should be aware of the prior abuses of Form S-8 in microcap fraud
cases.
---------------------------------------------------------------------------
\82\ Securities Act Release No. 33-7646 (February 19, 1999).
\83\ Securities Act Release No. 33-7647 (February 19, 1999).
---------------------------------------------------------------------------
25. ``Hot industry'' microcap stocks. Another characteristic of
microcap fraud cases is that they often involve stocks that are in
vogue.\84\ In the past, oil and gas ventures and mining operations,
as well as stocks of issuers with purportedly innovative products,
have been popular in frauds involving low-priced stocks.
---------------------------------------------------------------------------
\84\ See Douglass and Co., Inc., 46 S.E.C. 1189 (1978) (November
26, 1996)(mining operation); see also S.E.C. v. Bradley J. Simmons
and American Energy Group, Ltd, Litigation Release No. 15353 (April
29, 1997)(oil and gas company).
---------------------------------------------------------------------------
26. Unusual activity in brokerage accounts of issuer affiliates,
especially involving ``related'' shareholders. Many microcap frauds
begin with the deposit and sale of large blocks of an obscure stock
by a new and unfamiliar customer who often is affiliated with an
issuer.\85\ At the same time, the broker-dealer is encouraged to
make a market in the stock by the issuer.
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\85\ Laser Arms Report, 50 S.E.C. 489, 503; see also Butcher &
Singer, Inc., 48 S.E.C. 640, aff'd without opinion, 833 F.2d 303 (3d
Cir. 1987); Gotham Securities Corporation, 46 S.E.C. 723 (1976) (the
family of the broker-dealer's principal owned a significant amount
of the stock of Marcon Electronics Corp., which was a shell
corporation with no assets; the family benefited when the broker-
dealer manipulated upward the price of the Marcon stock).
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27. Companies that frequently change names. Frequent name
changes are another characteristic that we have seen in microcap
fraud cases. For example, Twenty First Century Health (TFCH) was
originally a company called Big Valley Energy, Inc. Big Valley then
changed its name to Biotronic Energy Engineering, Inc., then to The
Sonoron Group, then to Zorro International, Inc., then to Health &
Wealth, Inc., and finally became TFCH in 1995. At the promoter's
request, TFCH issued false audited financial statements that
recorded material, nonexistent assets.\86\
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\86\ Merle S. Finkel, Securities Act Release No. 7401 (March 12,
1997).
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28. Companies that frequently change their line of business.
Besides companies that frequently change their names, we also see
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companies that frequently change their line of business in microcap
fraud cases. For example, New Allied Development started out as a
uranium mining company that was a dormant public shell with no
assets.\87\ New Allied then acquired the rights to medical products
in exchange for its overvalued stock. Next, New Allied became a
vehicle to enter the gaming business purportedly to build a casino.
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\87\ New Allied Development Corporation, Securities Exchange Act
Release No. 37990 (November 26, 1996).
[FR Doc. 99-5299 Filed 3-5-99; 8:45 am]
BILLING CODE 8010-01-P