We continue to receive inquiries from management and shareholders of public companies about the Depository Trust Company (“DTC”). Many of these people believe that there is a larger DTC conspiracy in the works.
Frequently, companies engaging in certain types of reverse merger transactions find their securities without DTC eligibility.
A closer review of these transactions reveals that in most instances the reverse mergers involved public shells that were illegally acquired by the shell purveyor.
How Do Scammers Get Their Inventory of Public Shell Companies?
More often than not control of public shell companies is obtained through corporate hijackings involving bogus reinstatements and/or fraudulent state court custodianship and receivership actions. In these actions, the participants file verified pleadings that falsely state that a shareholder and/or board meetings were held. In reality, no shareholder or board meetings were held. Participants in these illegal schemes to obtain control of shell companies often misuse the exemptions from registration to issue free trading shares including Section 3(a)(10) of the Securities Act of 1933, as amended (the “Securities Act”) and the safe harbor provided by Rule 144. Despite the blatant illegal nature of these actions, securities lawyers, market makers and even transfer agents continue to assist these fraudsters by serving as gatekeepers of the fraud. The SEC and FINRA Become Proactive Between January of 2000 and present, the Securities and Exchange Commission (the “SEC”) has suspended or halted more than 1400 publicly traded companies. Most were dormant penny stock issuers suspended to prevent corporate hijackings by custodianship or receivership proceedings. Others were penny stock issuers engaged in massive pump and dump schemes. How DTC Fits In DTC serves as the only stock depository in the United States. When DTC provides services as the depository for an issuer’s securities, those securities can trade electronically. Without DTC eligibility, it is almost impossible for an issuer to establish an active market in its stock. Issuers must satisfy specific criteria established by DTC to receive initial DTC eligibility after a going public transaction. When a going public transaction is complete, the issuer must comply with DTC’s criteria to remain eligible for electronic trading regardless of whether a company goes public using a registration statement or reverse merger. Applying for DTC is the last step in the going public process and the last chance to prevent fraud before a company begins actively trading.
Even after securities become DTC eligible, DTC may limit or terminate its services. It is critical for private companies seeking public company status to consider factors that may impact DTC eligibility prior to their going public transaction if they want to establish an active market in their securities.
When DTC eligibility is denied, limited or terminated, issuers and their securities attorneys often express astonishment and scream foul play, asserting various conspiracy theories, each more ludicrous than the last. We have all read about issuers who self-righteously proclaim that their loss of eligibility was due to conniving short sellers, nefarious clearing firms and the purported “agenda” of the SEC to eliminate small broker dealers and microcap issuers. The reality is that most DTC Chills and Global Locks occur after reverse mergers, particularly when there is a suspicion of fraud such as that found in public shell companies created in state court custodianship and receivership actions.
DTC can limit its services by placing a chill (“DTC Chill”) on a security and terminate its services for a variety of reasons, but most often it is because securities lawyers have rendered flawed opinions or the issuer has engaged in illegal promotional activity. It should come as no surprise to the officers and directors of public companies that DTC reviews the issuance of free trading shares since it is the free trading shares DTC holds in its depository, under its nominee name CEDE & Co.
DTC has several options when concerned about the eligibility status of a newly eligible security, or when it detects fraudulent activity. These include limiting or suspending its services or making referrals to the enforcement divisions of FINRA or the the SEC or the Justice Department.
When DTC eligibility is lost, issuers will often tell their stockholders they have no idea what happened. Since only the company can direct its transfer agent to issue free trading shares, most often it knows exactly why DTC limited or suspended its services. Many officers and directors of microcap companies are facing the harsh reality that reliance upon a legal opinion will not provide them with an effective defense to SEC charges securities violations. What is really going on with DTC? DTCC’s Office of Corporate and Regulatory Compliance monitors unusually large deposits of microcap securities that are sent to DTC. it is looking for an indication that the issuer or persons associated with the issuer have violated the securities laws.
With penny stocks, this behavior typically involves the deposit of large blocks of unrestricted securities in reliance upon flawed legal opinions rendered in connection with convertible notes, reverse merger transactions or Rule 504 offerings.
Where any of the foregoing are present, the issuer should expect a review by DTC and should be prepared to provide a competent legal opinion from an independent securities attorney. Does FINRA Rule 6490 Have Anything To Do With DTC? DTC review is also prompted when issuers provide notice to the Financial Industry Regulatory Authority (“FINRA”), pursuant to Rule 6490, of name changes, stock splits, dividends, reverse mergers and spin-offs. While FINRA examines the corporate action prompting the notice under 6490, DTC reviews matters related to the issuer’s shares including the tradability of the securities it holds on deposit.
DTC staff may discover (previously undetected) illegally free trading share issuances based upon bogus legal opinions rendered by banned securities lawyers or other fraudulent activity that will persuade them to limit or suspend its services. In these instances, DTC may make referrals to appropriate regulators including the SEC’s Division of Enforcement. How will a DTC Chill or Global Lock Impact trading? A DTC Chill restricts DTC’s services, including limiting a DTC participant’s ability to deposit or withdraw chilled securities. A DTC Chill may last a few days or for an extended period of time depending upon the problems that caused the chill and the issuer’s willingness to address them. A “Global Lock” is a termination of all of DTC’s services to an issuer. Like a DTC Chill, a Global Lock may last a few days or much longer, depending on the reason for the action. If the fundamental cause cannot be corrected, then the security will be removed from DTC’s depository, and transactions in the security subject to the Global Lock will no longer be eligible for clearing at any registered clearing agency. When this happens, clearance and settlement of open market trades is significantly delayed because trades can only occur upon physical delivery of stock certificates between the buyer and seller’s brokerage firms. In such circumstances it could take weeks for trades to clear and settle.
DTC does not always disclose the reason for a Chill or Global Lock, nor does it suggest how long it will be in effect. DTC Chills and Global Locks are publicly announced on DTC’s website. DTC Chill Removal Specialists Recently, quite a few websites have popped up claiming their operators can remove DTC Chills and Global Locks. The irony is that most of these service providers participate in the activities that can cause the loss of DTC’s services in the first place. Some of these quick fixes are offered by the same lawyers who render flawed tradability opinions and the same transfer agents who knowingly or blindly accept the opinions that cause DTC difficulties in the first place.
Similarly, stock promoters with pump and dump websites now tout that they can remove DTC Chills despite the fact that their own dubious services have resulted in DTC problems.
There are only two people who can help you remove a DTC Chill, a securities attorney acceptable to DTC, who can render a tradability opinion concerning the issuer’s unrestricted shares held by DTC, and a DTC Market Participant, who can ask that DTC provide its services with respect to a security. Anyone else claiming he can secure DTC eligibility or remove a DTC Chill is unqualified to do so. Fairness Procedures On September 24, 2009, the Securities and Exchange Commission (“SEC”) filed a complaint in the United States District Court for the Middle District of Florida alleging that International Power Group (“IPWG”) had issued shares of common stock in violation of the securities registration requirements. The SEC reviewed the actions taken by DTC, and determined that DTC must provide issuers with fairness procedures, adding further that DTC’s suspension of its services to an issuer is subject to DTC review upon request.
The SEC did not make a determination that DTC’s suspension of services to IPWG was unwarranted. It merely concluded that DTC did not follow required fairness procedures. Unfortunately, the agency failed to define adequate fairness procedures precisely. Even with a fairness hearing there can be no assurance that DTC will resume its services; it continues to have broad discretion in these matters. Removing A Chill or Global Lock In some circumstances, DTC obtains additional information from the issuer and its securities counsel regarding the activity in question, and may decide not to limit its services or may remove a DTC Chill with respect to the security. Accomplishing this is not an easy task. Even with the SEC’s new requirement that DTC provide a fairness hearing, from a practical perspective nothing has changed for most issuers. A fairness hearing is expensive, and may take years to obtain. In the few cases in which removal of a Chill is possible, the process requires, among other things, an opinion from securities counsel concerning the (free trading) shares held on deposit by DTC and a DTC participant- usually a market maker- for services to be resumed. DTC reserves the right to refuse to rely upon the opinion of any issuer’s securities counsel. In recent months, the SEC has brought multiple enforcement actions against attorneys in connection with tradability opinions rendered for microcap issuers. Often these actions are preceded by a loss of DTC eligibility. The Solution Because DTC may choose to refer securities violations it discovers to the SEC’s Division of Enforcement, issuers need to consult with a qualified securities attorney at all stages of the DTC process, particularly when information must be provided by the issuer. The selection of counsel to address DTC problems, and other potential problems, should no longer be considered a routine legal matter. The most satisfactory solution for issuers seeking DTC eligibility is for the issuer to file a registration statement under the Securities Act of 1933 for either an Initial or Direct Public Offering.
Issuers expecting to obtain DTC eligibility in their going public transaction and maintain it once their going public transaction is complete need to recognize that they may be penalized if they go public in a reverse merger with a public shell company or use the services of securities professionals, including unregistered brokers, stock promoters, shell purveyors, investor relations firms, transfer agents and even securities lawyers who have been the subject of SEC investigations and enforcement actions.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton Florida, (561) 416-8956, by email at email@example.com or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855