SEC Proposes Rule 15c2-11 Changes – Form 211

sec 15c2-11 changes

SEC Proposes to Amend Rule 15c2-11

On September 26, 2019, the Securities and Exchange Commission (the “SEC”) announced proposed amendments to its Rule 15c2-11 of the Securities Exchange Act of 1934 (the “Exchange act”.  The purpose of Rule 15c2-11  is to establish requirements that must be met by broker-dealers before they can publish quotations for securities in the over-the-counter (OTC) known as the OTC Markets.  Issuers that are not compliant with Rule 15c2-11 will be relegated to the Grey Market until compliance is regained. OTC Markets companies wishing to achieve or regain compliance must do so by locating a broker-dealer willing to sponsor them.  The broker-dealer, using information supplied by the issuer, will file a Form 211 with the Financial Industry Regulatory Authority (FINRA).  FINRA will process the filing; it may request clarification or additional information until it’s satisfied.   Form 211 is commonly  used by smaller issuers after a Form S-1 registration statement has been filed with the SEC as part of a going public transaction.

Once the processing by FINRA  is complete, the Form 211 is sent to the OTC Markets. The OTC Markets will contact the sponsoring market maker to make sure he knows the form has been approved, and to inform him that OTC Markets will be opening the market for trading of the securities.  After 30 days, other broker-dealers will be free to make their own market in the securities without performing any review of the issuer.  That privilege has become known as the “piggyback exception,” because the new market makers will “piggyback” on the sponsoring broker’s Form 211.  From that point on, trading in the stock, facilitated by published quotations, will continue forever, regardless of what may happen to the company itself, as long as quotes have appeared on at least 12 days during the previous 30 calendar days, and no more than four consecutive business days have passed without a quotation.  That circumstance usually occurs for one of two reasons:  the stock is so illiquid that its market makers, detecting no interest at all, cease making a market; or the stock has been subjected to an SEC trading suspension, or, much more rarely, a FINRA “extraordinary event” (U3) halt lasting more than four trading sessions.  In those cases, the stock will be delisted to the grey market, where it will trade without quotes until its registration is revoked, if the issuer is subject to the SEC reporting requirements, or it’s deleted by FINRA as “inactive.”

The original purpose of Rule 15c2-11 was to ensure that current information about the company and the stock in question was in the hands of its sponsoring market maker, at least.  When it was last revised in 1991, most investors had a full-service broker, and the relatively few who traded OTC issues did so with their brokers’ help.  The brokers, in turn, could obtain information from the sponsoring market maker and pass it on to their clients.  In 1998, as the rise of the internet and the discount brokerages began to change the way stocks were traded, the SEC proposed amendments to Rule 15c2-11 that were not adopted.  The following year, the agency tried again, with a “reproposal.”  The idea was to limit the piggyback exception, require annual review of current information about the issuer, expand the information required for certain non-reporting issuers, and create exceptions for certain securities.  Like its predecessor, the “reproposal” was rejected.  Those opposed included broker-dealers, issuers, and attorneys.  Broker-dealers feared potential liability in civil actions.  Other market participants were concerned about reduced liquidity in OTC securities, less transparency, less competitive pricing, impaired access to capital for issuers, and increased compliance costs for broker-dealers.

Now the SEC  is trying again.  The issue was discussed at length at last October’s Roundtable on Regulatory Approaches to Combat Retail Investor Fraud, held at SEC headquarters in Washington on September 26, 2018, exactly a year before the new proposed rule was presented. One of its panels was dedicated to a discussion of the inadequacy of Rule 15c2-11 as it currently stands, and of the need for an amended version.  There was general agreement among participants that it was undesirable to allow the stock of companies with no current information to trade unhindered.  Yvonne Huber of FINRA’s OTC compliance team, raised the subject of reverse mergers:

I think under certain circumstances, piggyback eligibility should be taken away, such as in the reverse merger scenario, where there has been a completely different — a complete shift in the business line of a company, a complete change in ownership, a complete change in officers and directors.  That’s essentially a new company and it probably doesn’t make sense in that space to allow piggybacking to continue.\

Huber referred to the “new” company that merges with a public shell.  They can be problematic; they’re often intended to serve as vehicles for pump and dump operations, insider enrichment schemes, or other kinds of fraud and manipulation.  But the dormant shells themselves are just as bad and many times worse.  Often obtained through custodianship or receivership petitions in local courts, most have been dead as doornails for years.  But earlier, they were likely promoted multiple times, and may been encumbered with vast amounts of convertible debt.  They’ve typically been abandoned by management, and have no assets or operations.  Their only attraction is that they’re cheap for the shell peddler to get control of, and relatively cheap for the owner of a private company to buy.  Best of all, a reverse merger transaction is easy to do.  The process is advertised as quick though many times it is not.  The issuer’s market makers may not even know of the change in control.  The original Form 211 may have been filed a decade or more earlier, but it can still be relied on by the original sponsoring market maker, if he’s still around, and by all the other market makers who’ve piggybacked on it.

That problem is one the new proposed rule plans to address.

The Proposed Rule

The SEC’s mission is sometimes inherently conflicted.  One of its goals is to support capital formation—which presupposes a “business-friendly” approach—while another is to protect investors.  When possible, the Commission seeks to do both, but that isn’t always possible.

In the press release accompanying publication of the proposed rule, the regulator notes that “[t]he proposed amendments would provide greater transparency to the investing public by requiring that information about the issuer and the security be current and publicly available before a broker-dealer can begin quoting that security.”  The executive summary of the new rule begins:

Securities that trade on the OTC market are primarily owned by retail investors. Many issuers of quoted OTC securities publicly disclose current information about themselves. However, in other cases, there is no or limited current public information available about certain issuers of quoted OTC securities to allow investors or other market participants to make informed decisions regarding company fundamentals. The absence of current public information about such issuers can contribute to incidents of fraud and manipulation. The existing Rule is designed to ensure that a broker-dealer reviews basic information about a security and issuer prior to publishing a quotation in the OTC market. In practice, however, the Rule’s exceptions permit broker-dealers to publish quotations in perpetuity even when there is no or limited current information about the issuer available to the public or the broker-dealer, and even when the issuer no longer exists or has ceased operations. The proposed amendments are intended to modernize the Rule and in so doing better protect retail investors from incidents of fraud and manipulation in OTC securities, particularly securities of issuers for which there is no or limited publicly available information, and facilitate more efficient trading in certain more widely followed OTC securities.

Appropriate disclosure has always been important to the SEC.  When Franklin Delano Roosevelt was elected president in the depths of the Great Depression, one of his priorities was to encourage Congress to create legislation that could help prevent another market event like the crash of 1929.  Congress quickly produced the Securities Act of 1933, and FDR signed it into law on May 27, 1933.  Its focus was on disclosure.  Known as the “Truth in Securities Act,” it created rules  that established a standard for the disclosures that must be made in a prospectus for a securities offering.  The following year, the Securities Exchange Act of 1934 founded the SEC, and created an obligation for all issuers that were SEC registrants to file periodic financial reports apprising the markets, investors, and the general public of the company’s progress or lack thereof.

Congress and the SEC did, however, realize there were circumstances in which registration under Section 12(j) or 12(g) would be unnecessary or undesirable for certain issuers, and so exemptions from registration were created.  There was always an over-the-counter market, but it didn’t hit the bigtime till the Nasdaq was founded in February 1971 by the National Association of Securities Dealers (NASD).  The Nasdaq was the first electronic stock market.  It began as a mere quotation system, but soon began to execute trades.  And that is how the practice of broker-dealers assisting issuers with Rule 15c2-11 compliance developed:  it was only natural, because the new stock market had been founded, and its rules established, by broker-dealers.  For many years, Nasdaq companies needed sponsoring market makers who’d file Forms 211.  That practice ended in 2006, when the Nasdaq became a licensed national securities exchange.

The Nasdaq grew into a real stock market by the 1980s.  Not all issuers qualified for admission, or even wished to be admitted.  Trading in those stocks was overseen by the NASD, which also performed certain administrative work for OTC companies, such as the processing of corporate actions.  The over-the-counter market was called the OTC Bulletin Board, or OTCBB.  OTCBB issuers were expected to be fully-reporting SEC registrants, but as time went by, many became severely delinquent and stopped filing altogether.  Companies that had no registered stock, and had never made disclosure of any kind, traded on the National Quotation Bureau.  Quotes for NQB equity issuers were printed once a day on sheets of pink paper, and so became known as Pink Sheet issuers.  Trades in OTCBB stocks could only be executed by telephone; that remained true even after it was possible for buyers and sellers to place orders online with discount brokers.  The Pinks were also traded by phone, and without any centralized reporting facility, execution could be extremely difficult.

In 1999, the SEC decided far too many OTCBB issuers were delinquent filers, and set a deadline by which they needed to catch up with their financial statements or be delisted to the Pinks.  The result was an enormous increase in the number of Pink issuers.  As it happened, not long before, a group of investors headed by Cromwell Coulson had purchased the National Quotation Bureau, and in 2000 renamed it Pink Sheets LLC.  The group also invented an electronic trading platform it introduced in the same year.  It was originally called Pink Link.  The result was faster and easier trade execution.  Better yet, Pink Sheets didn’t charge broker-dealers to use its platform; the OTCBB did.

In the late 1990s and early 2000s, discount brokerages offering online accounts and dramatically lower commissions appeared on the scene.  Some of their clients—the risk takers—began to trade more often, and once the dotcoms had crashed and burned, many turned to penny stocks for thrills.  As the new century progressed, Pink Sheets changed its name to OTC Markets Group, and Pink Link became OTC Link.  FINRA tried to sell the OTCBB, but found no takers.  It abandoned the related website, leaving the playing field to OTC Markets.  OTC Link is now an Alternative Trading System (ATS).

The Proposed Changes to Rule 15c2-11

The object of the new proposed changes to Rule 15c2-11 is the same as it was in 1998 and 1999:  to cut back on penny stock fraud, which may now be even more rampant than it was 20 years ago.  When Jay Clayton became SEC chair in 2017, he declared he was “surprised” by the potential for fraud he saw in the microcap market, and it was because of that he encouraged the director of the agency’s Division of Trading and Markets to set up the roundtable in September 2018 whose eventual fruit was the new proposed rule.

At 224 pages, the proposal is long and complex.  Following the executive summary’s discussion of the importance of current information, an overview of the planned changes is offered.  The SEC hopes to:

  • Make certain information about every issuer will be current and publicly available at no cost before a broker-dealer can publish a quote for the security. In the absence of that information, exceptions to the requirement would either be unavailable or more limited than is the case now.
  • The “piggyback exception” will be limited, but not eliminated. Pointing out that “[u]nder its existing formulation, this exception has been used by broker-dealers to continuously quote a security over many years, even when the issuer of the security no longer exists,” the new rule will strive to ensure that actual current information is available when a stock begins to trade, and is reviewed annually to ensure there’ve been no major changes.
  • Limit the use of the existing unsolicited order exception for quotations on behalf of company insiders if current information about the issuer is unavailable.
  • Create a new exception that would permit broker-dealers to publish quotations without conducting an information review for issuers with significant assets and trading volume. The Commission believes such issuers are less susceptible to the kind of fraud the new rule is intended to prevent.
  • Allow “a qualified IDQS that meets the definition of an ATS to conduct the information review that is currently only permitted to be conducted by broker-dealers that publish or submit quotations.” There’s no need to look far for an Interdealer Quotation System that’s also an ATS:  it’s the perfect description of OTC Markets’ OTC Link.

The new rule’s provisions are very similar to those proposed in the failed 1999 rule, though it appears a few adjustments have been made in the hope it will have more appeal to broker-dealers, ATSs, issuers, and investors.

From the outset, the new proposed rule seems to us to over-complicate and over-explain simple things.  Is there really any need to describe the correction of typographical errors and inadvertent grammatical mistakes in the rule as it stands now?  The proposal bristles with user-unfriendly language like this:

Proposed paragraph (f)(7) would except from the Rule’s issuer information and review and document collection provisions in proposed paragraphs (a) through (c), and (d)(1), the publication or submission, in a qualified IDQS, of a quotation concerning a security where that qualified IDQS complies with the requirements of proposed paragraphs (a) through (c) of the proposed Rule.

No one would be blamed for not reading the whole thing.  Wouldn’t it have been simpler to offer an explanation of the significant changes proposed, accompanied by an appendix in which the text of the current rule and the new proposed rule are compared paragraph by paragraph?

The explanatory text creates and comments on four different types of issuers:  1) companies that filed an initial registration statement (a Form S-1) under the Securities Act (a “prospectus issuer”); 2) companies that filed a notification under Regulation A (a “Reg A issuer”); 3) companies subject to the Exchange Act’s or Regulation A’s periodic reporting requirements or is the issuer of a security covered by Section 12(g)(2)(B) or (G) of the Exchange Act (a “reporting issuer”); companies that are foreign private issuers exempt from registration (an “exempt foreign private issuer”); and (5) companies that don’t fall into any of the above categories (a “catch-all issuer”).

It’s difficult to see why these distinctions are necessary; they employ some terms the SEC has never used before in any context we’re aware of.  The 1999 proposed rule addressed only “reporting companies,” “non-reporting companies,” and exempt foreign issuers (which are exempt because they’re required to make disclosures in their home countries, usually because they trade on a stock exchange there, and are required to disclose those disclosures to the SEC if they wish to trade on the OTC market).  For the purposes of the new rule, what meaningful distinction is there between a Securities Act company and an Exchange Act company?  Both must make periodic reports to the SEC, and those reports will satisfy the “current information” requirement of the new rule.  The “catch-all” companies are not, as the name suggests, a variety of different kinds of companies, but simply non-reporting OTC issuers.

Interestingly, the terms “prospectus issuer” and “catch-all issuer” do not appear in the proposed rule itself, the text of which begins on page 212 of the document.

Current Information

The SEC has never really defined “current information,” though Rule 15c2-11 has always required that sponsoring market makers possess it before  submitting a Form 211 to FINRA.  A definition is, however, offered in the text of the new rule itself, in paragraph (b), which begins on page 215.  What’s needed for reporting companies and exempt foreign issuers is uncontroversial.  A list of information required from non-reporting issuers is provided on page 218.  It’s extensive, but not unreasonable.  Broker-dealers submitting Forms 211 for non-reporting companies have always needed to gather “current information.”  In that context, “current” seems to mean “within the past 12 months.”  What’s new is that now they need to keep a record of it, make sure it’s publicly available, and review it periodically.

In practical terms, the broker-dealers probably wouldn’t be fulfilling the public availability requirement themselves.  It seems clear that the SEC would consider disclosures made to OTC Markets adequate.  What is not clear is what level of OTC Markets disclosure would suffice:  must it be Pink Current Information, which, after all, includes the phrase “current information”?  If so, that would mean a great many OTC companies would be ineligible to trade, because they’d lack that kind of current information.  They’d be bumped to the grey market, where most would fade away and eventually have their tickers deleted by FINRA.  Of course, those willing to upgrade to Pink Current status and maintain it would have no problem.

As noted above, the new rule will permit OTC Markets/OTC Link to file Forms 211.  The broker-dealers who’ve been doing that work for decades may not mind, as they’re not permitted to accept compensation from the companies they sponsor, or from anyone associated with those companies.  The result could be that OTC Markets will in the future become the principal sponsor of Forms 211.  Perhaps they’d encourage the companies that approached them to seek Pink Current status, which comes with a $5,000 annual price tag and a $1,000 application fee, for use of OTCM’s OTC Disclosure & News Service.  OTC Markets has long advocated for allowing broker-dealers to charge for preparing Forms 211, so that might be in the works eventually.  It would be another useful income stream.

But what of companies that don’t want to subscribe to any of OTC Markets’ services, and are uninterested in attracting attention?  Such companies exist, and some of them are quality enterprises that show growth year over year, and may even pay dividends.  There aren’t yet many comment letters on the proposed rule at the SEC’s website, but nearly all that have been posted are from individual investors who believe their research skills have led them to discover superior companies that, as they like to say, fly under the radar.  Those people are afraid that if the rule is adopted, the current information requirement will mean these issuers will be knocked to the greys, where they’ll lose what little liquidity they have, and they, the investors, will lose what are in some cases substantial investments.

The commenters don’t, however, seem to have read the new rule as closely as they should have.  Some of the companies they discuss do provide current information that’s publicly available.  It just isn’t available at Edgar or at OTC Markets.  Apparently many do make annual or biannual disclosure at their websites, or to investors or potential investors who call or write requesting it.  That should be sufficient, as long as the information is not “restricted by user name, password, fees, or other constraints.”  Companies unwilling to comply would, however, find themselves trading on the grey market.

The proposed rule also contemplates an obligation for broker-dealers to review the available information for the companies in which they make markets, and to publish quotations.  The rejected 1999 rule was admirably clear on that point:  “The amendments require a broker-dealer to review the specified information annually if the broker-dealer publishes priced quotations for the security.”  The new proposed rule appears to require the same thing, but rather less explicitly.  That is unfortunate, because limiting the quotation of companies “for which there is no or limited current information… and even when the issuer no longer exists or has ceased operations” appears to be a worthy goal.  There is nothing controversial about the need for current information.  As the SEC notes, the broker-dealers need not solicit additional information from the issuer when they conduct their annual reviews; they need only verify that what’s needed, exists.

The Piggyback Exception and Shell Companies

A provision of the current Rule 15c2-11 that is controversial is the so-called “piggyback exception.”  When the rule was created, the supposed advantage a sponsoring market maker would gain from submitting a Form 211 was that once it had been processed and the stock begins to trade, only he could make a market in it for 30 days.  After that, other market makers could “piggyback” on his Form 211 without filing anything themselves.  The sponsoring market maker’s month of exclusivity may have been meaningful at the time.  Nasdaq issuers then needed Forms 211, too, and perhaps that created lucrative opportunities for market makers.  But any real advantage disappeared when the Nasdaq became a national exchange, and the language about Nasdaq issuers will be removed from this new version of the rule.

The 1999 proposed rule would have entirely eliminated the piggyback exception.  That proved to be an extremely unpopular idea, due to fears it would impair liquidity.  The framers of the new rule considered eliminating the exception.  But in the end, it was decided that the investing community would be best served by leaving it intact.  According to FINRA, a total of 538 Forms 211 were submitted in 2018.  Surprisingly, the largest number—391—were for exempt foreign issuers.  U.S. reporting issuers contributed 211.  Only 56 were from what the SEC calls “catch-alls,” and we would call “non-reporting companies.”

Generally speaking, it doesn’t seem that eliminating the piggyback exception would be meaningful.  But there’s one circumstance in which it could make a positive difference.  At the 2018 roundtable, there was a good deal of discussion of the problem of reverse mergers involving dormant public shells.  In them, the owner of a private company who wishes to take it public cuts a deal with a shell vendor, of which there are a great many these days. We wrote about the popularity of these transactions earlier this year.  Were the SEC to eliminate the exception entirely, reverse merger companies would be dumped to the greys upon completing the transaction, because the “current information” the broker-dealers had relied on to publish quotations for the shell would no longer be valid.

But in most cases it was no longer valid to begin with.  Reverse merger transactions are conducted with public shells, as noted, not with operational companies.  While in recent years the SEC has dedicated considerable resources to investigating and bringing enforcement actions against fraudulent Securities Act issuers that masquerade as legitimate companies by first filing fraudulent Forms S-1 and then conducting reverse merger transactions with “new management”—usually the people who’d been in control all along, and often people interested in launching a pump and dump operation—they’ve shown no interest at all in custodianship shells.

In the proposed rule and elsewhere, the SEC offers the definition of a “shell company” as:

…any issuer, other than a business combination related shell company… or an asset-backed issuer… that has (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.

Noting that while in the past that definition was applied to SEC registrants only, in the proposed rule, the definition “is not limited to companies that have filed a registration statement or have an obligation to file reports under Section 13 or Section 15(d) of the Exchange Act.”  It will instead “cover all issuers of securities because the provisions of Rule 15c2-11 apply to publications and submissions of quotations for securities of reporting issuers as well as catch-all issuers.”

The new rule additionally provides that shell companies will lose eligibility for the piggyback exception.  That means they will not be quoted or, if they were once operational but become shells, they will lose compliance with Rule 15c2-11 and be relegated to the grey market.

That is very important.  It means custodianship shells, which have usually been abandoned by management, will now be considered shells in accordance with the SEC’s definition.  Some of them are registered—but very delinquent—SEC filers when a shell vendor petitions for custodianship, but once his petition is granted, the first thing he does is  file a Form 15 to deregister the issuer.  In the past, that served two purposes:  it relieved the company of the need to catch up with its filings, and saved it from shell status.  If the proposed rule is adopted, those custodianship and receivership shells will instantly go grey, and become worthless to anyone interested in a quick and easy merger transaction.  It should be possible for the private company to complete the merger and then locate a sponsoring broker-dealer willing to file a new Form 211 based on new current information pertinent to the merger’s surviving entity, but that will eliminate a fair amount of the speed and certainty prized by private issuers interested in going public as fast as possible.  It will probably lower the value of the shell considerably, too.

Who would decide what’s a shell company, registered or not?  The Commission explains in a footnote that the new rule “would permit broker-dealers, qualified IDQSs, and registered national securities associations to determine whether an issuer is a shell company based on their review of the issuer’s information.”  For all practical purposes, that means the determination could be made by a broker-dealer, OTC Markets, or FINRA.  FINRA processes Forms 211, and in some cases holds them until it receives additional information, or outright rejects them.  What if disagreements about a shell determination arise?

In the “burdens” section, the Commission breezily calculates that it should take a broker-dealer four hours to compile “current information” for the submission of a Form 211 for a reporting issuer, and eight hours for a non-reporting issuer.  A broker-dealer with which we’re familiar spends a great deal more time than that, and has been instructed to do so by the SEC.  For the issuer, there’s an 18-page “15c2-11 Listing Application Checklist.”  If the issuer has questions, the broker-dealer must answer them; if the issuer makes mistakes, the broker-dealer must see to it they’re corrected.  The broker-dealer also has a 7-page list of “15c2-11 Red Flag Issues” that is to be consulted by the employee working on the current submission.  A “Shareholder Data Spreadsheet must also be compiled, showing how each individual or entity’s stock was acquired, and what exemption from registration was used.  The “principal officer” who hired the broker dealer will need to sign an affidavit attesting to his honesty and that of other officers, directors, affiliates, and shareholders, and greater-than-5 percent shareholders will have to fill out a questionnaire.  The broker-dealer may also hire an outside firm to conduct background checks.

That seems to be more than the work of four hours.  (The broker-dealer in question generally deals with reporting issuers.)  And in addition, the SEC expects whoever submits the 211 to determine whether the company is a shell.  In the case of registered issuers, shouldn’t that be a regulator’s work?  Before asking a broker to file a Form 211, the issuer will have filed a Form 10 or, more often, a Form S-1 with the SEC.  Either will be read and commented on by reviewers from the SEC’s Division of Corporation Finance.  The company may be required to file a number of amendments based on those comments.  If the reviewer doesn’t flag the issuer as a shell, why should the broker-dealer who files a Form 211 after the SEC has deemed the registration statement effective—or, in the case of a Form 10, it has become effective automatically—be saddled with the responsibility of determining shell status that went unnoticed through several amendments?

We believe the SEC’s aims are admirable; it recognizes that fraud in the OTC market is a problem that needs to be addressed.  Does this new proposed Rule 15c2-11 take the right approach, or does it expect too much of broker-dealers who aren’t even compensated for the work involved in the submission of a Form 211?  Perhaps its real purpose is to move those broker-dealers out of the way, leaving OTC Markets to file nearly all 211s, and to use its own website as the “information repository” briefly referenced, but never described, in the text of the proposed rule.  That might not be a bad solution from the practical point of view, but it could be asked whether increasing the power and influence of OTC Markets would be desirable.

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 protected] 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 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.