SEC Speaks Reverse Mergers – Going Public
On March 8, 2019, Securities and Exchange Commission (SEC) Chairman Jay Clayton and Brett Redfearn, Director of the agency’s Division of Trading and Markets, spoke at Fordham University’s Gabelli School of Business in New York City. They addressed a variety of topics, but a few points of interest stood out including their discussion of reverse mergers in going public transactions. One was the need to do more to combat retail investor fraud. That had been the subject of a lively roundtable discussion that took place at SEC headquarters in Washington on September 26, 2018. Clayton and Redfearn wanted to discuss the conclusions drawn from that and two other roundtables convened in 2018, and to suggest new directions, along with some plans for reform, for 2019.
Clayton stressed, as he had at the roundtable, his fidelity to five principles that serve as his guide. They are:
First, fidelity to the SEC’s mission to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation; Second, focusing on the long-term interests of our Main Street investors; Third, facilitating public transparency that can energize competitive forces to benefit investors; Fourth, retrospectively reviewing Commission rules to assess whether they are functioning as intended, particularly as technology spurs new market mechanisms and trading practices; and Fifth and finally, coordinating and communicating with other regulators and the stakeholders in the markets that we oversee.
Shortly after Clayton became chair in 2017, he declared he was “surprised” by the potential for fraud he saw in the microcap market and in initial coin offerings (ICOs). In his speech at Fordham, he reiterated those concerns, saying he was “sure that more can be done to help prevent fraud and manipulation in penny stocks.”
We’re sure of that as well, given that not a great deal is being done about it now. A number of possible remedies were discussed at last September’s roundtable, and are worth looking at here.
The Roundtable on Regulatory Approaches to Combating Retail Investor Fraud
Brett Redfearn presided over the event; Jay Clayton made opening comments and offered occasional comments throughout the day. Among the participants were representatives of the Financial Industry Regulatory Authority (FINRA), OTC Markets Group, the New Jersey Bureau of Securities, a major market maker, AARP, and several transfer agencies. The Depository Trust & Clearing Corporation (DTCC), which had contributed to the SEC’s Roundtable on the Execution, Clearance and Settlement of Microcap Securities in 2011, played no role.
The roundtable was webcast, and eventually a transcript of the proceedings was produced. It merits a read. Clayton and several Commissioners kicked things off with general comments, and then Redfearn praised the Enforcement Division for its recent takedown of a Ponzi scheme whose investors lost more than $345 million. He briefly praised a few other enforcement initiatives, and then turned to the subject of the first panel: the types of fraudulent and manipulative schemes that are currently targeting retail investors, with special attention to the role played by internet chatrooms, online platforms, and social media.
The first speaker from the panel, Charu Chandrasekhar, spoke to that point. Chandrasekhar is Chief of the Retail Strategy Task Force in the Enforcement Division. The RSTF, created in September 2017, has a broader remit than the Microcap Task Force, of which not much has been heard lately. As Chandrasekhar explained, it deals in Ponzi schemes, boiler room schemes, misappropriation and churning by brokers, market manipulation and pump and dumps, and fraud involving cryptocurrencies. It also works to raise investor awareness about frauds that could harm them.
Chandrasekhar is interested in the right things:
So in terms of areas of emerging risk for retail investors that concern me the most, I would say the first would be the central role of the internet in propagating retail investor fraud. We see many of these schemes unfolding in very pernicious ways across the internet. Second, financial professionals who are bad actors in the space. And I would say third, retail investors who are purchasing products that aren’t necessarily suitable for them in terms of the complexity and appropriateness.
The role of the internet is key. While boiler rooms that prey largely on the elderly still exist, and may even be on the increase, a great deal of fraud, and especially penny and cryptocurrency fraud, is conducted or enabled online. Nearly all penny players use discount brokerages and trade online. They do research—sometimes extensive, but more often limited—online, and most participate in online chat forums of some kind. In recent years, Twitter has become extremely important as a place to post stock tips, disseminate them across the platform, and to pump them. Popular Twitter (and Skype) groups often have leaders who could be considered semi-pro or amateur promoters, regularly frontloading “picks” before distributing them to their larger group of followers. Some of hese groups can generate hundreds of millions of shares in volume for their plays. While the volume doesn’t last long, because the promo lacks the kind of financial support that buys wash trading and the like, it can for a short time cause a stock’s price to gain hundreds—sometimes even thousands—of percentage points. And then the pump is dumped.
Cameron Funkhouser of FINRA’s Office of Fraud Detection and Market Intelligence (OFDMI) seconded Chandrasekhar’s concerns. OFDMI receives tips and complaints itself, and also works closely with the SEC and with state regulators. In 2017 it referred about 850 matters to the SEC. Funkhouser sees a great many microcap pump and dump schemes that, he says, a re “very large-scale operations that are borderless. So… the perpetrators of these schemes are potentially inside the U.S. and outside the U.S. The victims of these schemes are both inside the U.S. and outside the U.S.” Thanks to the ubiquity of the internet, scammers can work with colleagues around the world to defraud victims located around the world.
Chris Gerold, Chief of the New Jersey Bureau of Securities, had a different perspective. He deals less with pump and dump schemes and more with Ponzi schemes and fraud committed by investment advisers; fraud more like to be committed in person than online. More recently, he’s seen a new trend: people receiving phone calls from local numbers made by people pushing a penny stock. They encourage the recipient of the call to go online and buy the stock through his broker. It turns out the phone numbers are spoofed, and the calls come from overseas crooks. Jean Setzfand of AARP deals, not surprisingly, with fraudsters who prey on the elderly. Like Gerold, she frequently encounters affinity scammers, who pitch to churchgoers, people in the military, ethnic communities, and more. One of the biggest penny scams of all time, CMKM Diamonds (CMKX), appealed to a number of groups: servicemen, NASCAR fans, Christians, and eventually crazy conspiracy enthusiasts obsessed with the Illuminati.
Clayton eventually joined in the discussion to make a few points, noting that investors should ask people trying to sell them stock, or even trying to sell them on a stock, whether they’re registered with the SEC or in the state as an investment professional. They should also ask whether their investment is registered. If it’s not, Clayton cautions that “you really need to take a pause.” He feels the best question to ask is whether the investment is backed by audited financial statements; for him, that’s what separates the less speculative from the very speculative. Unfortunately, he may not realize that many people just don’t care. They trade on their phones and buy based on recommendations found on Twitter. They’ve never read an audited financial statement in their lives. The SEC’s efforts at educating investors are commendable, but a great many just don’t want to learn.
Rule 15c2-11
The second panel, moderated by Val Dahiya of the SEC’s Division of Trading and Markets, addressed old and new ideas about SEC Rule 15c2-11. Rule 15c2-11 was created to ensure that the stock of public companies wouldn’t begin to trade until the broker-dealers who’d publish quotations made sure they understood what the company was about. The rule requires that before an OTC security can begin trading, it must find a sponsoring market maker willing to familiarize himself with information supplied by the company and then fill out a disclosure document called a Form 211. The Form 211 will be submitted to FINRA’s market regulation OTC compliance team for review and processing. Once a Form 211 is processed, after 30 days, other broker-dealers may “piggyback” on the first broker’s submission.
Dahiya explained that “[i]n 1999, the Commission sought to limit the piggyback exceptions, require annual review of current information about the issuer, expand the information required for certain nonreporting issuers, and create new exceptions for certain securities, amongst other things.” The 1999 submission was actually a “reproposal” of a revised rule put up for public comment in February 1998. That proposal had not been received favorably. Those opposed were broker-dealers, issuers, and attorneys. Broker-dealers feared potential liability in civil actions. Other market participants were concerned about reduced liquidity in OTC securities if market makers decided not to play, less transparency, less competitive pricing, impaired access to capital for issuers, and increased compliance costs for broker-dealers. Some argued that the proposed changes would do nothing to stop microcap fraud.
The 1999 proposal contains a lengthy appendix intended as a kind of guide for broker-dealers reviewing information received from a new public company. The appendix provides detailed suggestions for how a broker should approach his review, complete with a list of 28 red flags that should catch the broker’s eye. Some—like insiders who’ve been criminally convicted—are obvious. Others are issues not necessarily indicative of fraudulent activity, but enough to ring muted alarm bells: frequent name changes for the company, involvement in a “hot” sector, frequent changes in the company’s line of business, unusual auditing issues, inconsistent financial statements, and so on.
The 1999 reproposal, like the 1998 original, was in the end not adopted. But Dahiya urges broker-dealers to read the red flags, because most are as valid today as they were 20 years ago.
Yvonne Huber, a senior vice president who heads FINRA’s OTC compliance team, explained how the regulator handles Forms 211. Like the SEC’s reviewers in its Division of Corporation Finance, members of Huber’s team do not judge the merits, or lack thereof, of the company or its business plan. Their interest is only in ensuring the submission is in compliance with the requirements of Rule 15c2-11.
Once the processing is complete, the 211 is sent to OTC Markets. Daniel Zinn, OTC Markets’ general counsel, explained what happens next:
Upon receiving a Form 211, an approved 211 from FINRA, we will do a couple of things. We will contact the applicable broker-dealer to make sure that they understand the form has been approved and that we will open the market for them to be able to quote. We will also then start tracking the time line and making sure that they meet their responsibilities, that the time line is met before other brokers can begin quoting on what’s called piggyback eligibility…
While Zinn appreciates the work done by the SEC and FINRA back in the ‘90s, he’s proud of the changes made by OTC Markets since then. Most importantly, the company changed a market in which quotes were printed on paper and trades were executed by telephone to a “real-time electronic market”.
Laura Gold, senior counsel to the SEC’s Division of Trading and Markets, is involved in administering Rule 15c2-11. She asked how, should the agency advance a new rule, it could “achieve an appropriate balance between capital formation and retail investor protection.”
And therein lies the rub. Markets tend to perform better, at least in the short run, when unencumbered by aggressive regulation. But abuses will be overlooked, and individual investors may suffer. Huber expressed a cautiously optimistic view, suggesting that investors who feel their interests are protected will be more confident, and more willing to participate in the market, and that issuers will appreciate and benefit from their interest.
The Piggyback Exception and Reverse Mergers
Bringing the discussion back to a consideration of reforms that may be desirable, Dahiya introduced a topic on which “everyone has strong views,” the piggyback exception that allows other market makers to publish quotations based on the Form 211 filed by the sponsoring market maker after 30 days. Subsequently, unless the issue isn’t quoted by anyone for more than four trading sessions, it will be quoted, and continue to trade, forever.
Dahyia pointed out that “the piggyback exception… allows broker-dealers to quote even for issuers who don’t have currently available information. And oftentimes, issues that are dormant or no longer exist.” Does that make sense? Huber didn’t think so, and suggested “putting a sunset” on the exemption when a company is completely dark.
We find it surprising that this should even be a matter for discussion. Why on earth should nonexistent companies—known to penny stock observers as “zombie tickers”—be allowed to trade at all? Strangely, the SEC has no available mechanism for disposing of them permanently, if they’re Pinks. The agency can, at least, revoke the registration of delinquent reporting companies.
Huber, the advocate of deep-sixing the piggyback exception for dormant or dead companies, noted that FINRA does take action if notified that a company hasn’t had trading activity or performed corporate actions “for a certain [unspecified] period of time.” It deletes the ticker as belonging to an “inactive issuer.” Notice of the action will appear in the Daily List. If a stock has only one active market-maker, FINRA will often call the firm and explain that the company is inactive, and the firm will take down its quote and the issuer will be declared inactive.
Huber then brought up 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.
We agree with her wholeheartedly. What happens to those zombie tickers referenced above? Many are acquired, one way or another, by shell vendors. The vendors may purchase them from the owner, typically a CEO who’s lost interest or needs cash, or they may petition for custodianship in a state court where the corporation, whose corporate charter will by then have been revoked, is domiciled. For a small filing fee and the cost of hiring an attorney, just about anyone can acquire a dormant shell. Or dozens of them. For a total outlay of a few thousand dollars, the shell peddler will soon control a public issuer he can sell for as much as $100,000, depending on its condition. The private company purchasing the shell will then effect a reverse merger with the shell. Dormant shells are big business. Sometimes the custodians are, or will eventually be, sanctioned by the SEC. Other times the shells are purchased by individuals or entities who are, or eventually will be, sanctioned by the SEC. Harold Bailey (“B.J.”) Gallison, Big Apple Consulting, Adam Tracy, and Donna and David Levy are only a few of many, many examples of custodians and their clients.
The shells are often used in pump and dump or insider enrichment schemes and then sold again. The recycling of custodianship shells in reverse mergers is, in our view, the greatest enforcement failure of the SEC in the penny stock markets. For awhile, the agency seemed to be getting a grip on the problem. In 2012, it announced a program called Operation Shell Expel, whose purpose was to deal with dormant Pink shells by suspending them. Because they’d then lose compliance with Rule 15c2-11, the companies that still actually existed would need new Forms 211. Market makers wouldn’t be enthusiastic about sponsoring companies that had been smacked with trading suspensions, and FINRA wouldn’t be keen on processing them.
Shell Expel started off with a bang. On May 14, 2012, trading was suspended in 379 dormant shells. More mass suspensions followed through 2015. And then they came more or less to a stop. Shell vendors, who’d cut back on their custodianship petitions, mindful of the fact that they might be acquiring worthless properties, renewed their activities. Old bad actors reappeared, and new ones arrived on the scene. It is difficult to understand why the SEC lost interest in a program that was not only successful, but also inexpensive and easy to administer.
At the beginning of the roundtable, Brett Redfearn observed with pride that in 2017, the Commission suspended trading in the securities of 309 issues. But most of them were reporting companies that were delinquent filers. There were relatively few suspensions for suspected fraud, and have been even fewer in 2018 and 2019.
Right now, reverse mergers are extremely popular among penny stock traders. They comb the dockets of the Clark County Court in Las Vegas, looking for new custodianship petitions. They the frontload the stock in question, hoping that in a few months it’ll be sold by its new custodian to a private company interested in promoting it. While that isn’t how the scenario always plays out, certain custodians—Joe (“The King of Shells”) Arcaro, David Lazar—are favored enough to warrant a following that reports on their every move. The result is often a self-fulfilling prophecy: shells rise on anticipation of sale to a new owner, preferably one whose private company is in a hot sector. Eventually the hype plays itself out. The effect is the same as that of a paid-for pump and dump.
The SEC seems seriously to be considering pulling the plug on piggyback privileges for reverse merger stocks, requiring market makers to obtain detailed information about the new entities before publishing quotations for their securities. That would be a step in the right direction.
Transfer Agents
The last session of the day began with a discussion of transfer agents and how they can help prevent investor fraud. A subject of immediate interest to the panel was the process for removing restrictive legends. Moshe Rothman, another official from the SEC’s Division of Trading and Markets, got the ball rolling by saying one of his priorities was “curbing illegal distributions of securities in violation of Section 5 of the Securities Act.” These illegal distributions are not uncommon with microcap companies. Rothman feels transfer agents are in the position to act as gatekeepers.
Unfortunately, the transfer agents chosen to participate were all from relatively large firms. One participant, Mark Harmon, was not himself a transfer agent, but a lawyer who represents transfer agents without in-house counsel. He’s more likely to encounter the very small, often mom and pop, firms that service many penny companies.
When asked how a request to remove a restrictive legend and the accompanying attorney’s Rule 144 opinion letter are evaluated, one panelist rather surprisingly said:
So the first thing we do is we review the letter to make sure it’s consistent. Does it actually say what it’s supposed to say? Does it have the required time parameters of ownership? Does it say everything — does it look professional? Let’s start with that.
What we also do is we check — and we started this ourselves several years ago at a prior transfer agent and I’ve carried it forward to where we are today. We check a list of attorneys who have been sanctioned by the Commission, particularly for bad 144 letters. And there’s a number of those that we’ve uncovered. But, in addition to that, and something that we uncovered — that we discovered just a little while ago, is that one of the market participants, OTC Markets, actually maintains a page that has bad attorneys and bad accountants and others, and we do look at that as well to make sure we didn’t miss anybody.
Penny players may or may not be competent traders, but most are well-acquainted with OTC Markets’ Prohibited Service Providers page. It seems hard to believe a transfer agent would have been unaware of it until recently. Many, though not all, transfer agents have regular contact with OTC Markets, because OTC Markets has launched an initiative to persuade transfer agents to update the company’s share structure regularly. That is helpful information that many have agree to provide, unless forbidden to do so by the issuer.
Harmon observed that for his small clients, ordinary legend removal, requested when the holding period for restricted stock has expired, is not particularly problematic. It’s the debt conversions, 3(a)(10) actions, and other scenarios he doesn’t describe that bother those clients. And while they know the SEC would like them to act as gatekeepers, that concerns them:
The problem for the smaller agents then is they try to get information but don’t have any authority to compel providing information, so they’re stuck between trying to amass the information and their duty and obligation to effect the transfer because, under state law, the failure to remove the legend is a violation of state law and exposes them to liability for conversion damages or delay damages on the value of the stock.
A panelist from Computershare experiences none of those problems, because it’s one of the largest transfer agencies in the country, and has created a detailed guide it uses to train staffers. All the participants, however, seemed uncomfortable because what the SEC wants them to do could create conflicts for them with the state laws described by Harmon. They all support the idea of a regulation pointing to specific requirements for various scenarios, saying it would make it easier for them to deal with the many clients who tell them another transfer agent they’ve dealt with doesn’t ask for as much information or supporting documentation.
FINRA and Trading Halts
FINRA’s Rule 6440 gives the regulator the authority to impose trading halts in OTC securities under limited circumstances. There are three general types of cases: the foreign regulatory halt, the derivative halt, and the extraordinary event halt, also known as the U3 halt. The first two are self-explanatory, but the third, which was of the greatest interest to the panel, is not. It’s similar to an SEC trading suspension in some ways. It prohibits quoting and trading by FINRA members, and if it lasts more than four trading sessions, the issuer will lose its compliance with Rule 15c2-11 and be delisted to the dreaded Grey Market. It’s different from a suspension in two important ways: it can be imposed during the trading session, and it can be renewed every 10 trading days. By law, SEC suspensions cannot be rolled over.
The moderator for the final panel, Racquel Russell, opened discussion to the participants without actually asking a question, and so didn’t get a great deal in the way of answers. Cromwell Coulson raised some interesting points, noting that perhaps what the OTC market needs is an action that stops an undesirable activity immediately, but doesn’t have the permanent consequences of and SEC trading suspension, and adding that perhaps FINRA could act more nimbly than the SEC. He said further that he’s inclined not to favor frequent intervention, because in the long run a transparent market will correct itself.
The SEC’s Michael Paley, co-chair of the Microcap Task Force—the entity that researched and brought all the Shell Expel suspensions—lamented that “sometimes it feels as if we’re not really making a dent.” He’s most certainly right about that. He concluded, “And that’s why I’m very glad that we’re also talking about FINRA trading halts because with the limit on SEC resources… to the extent that we can find a way for FINRA or others to act in this area, it would be very helpful in cleaning up the market.” And so we learn that at least one person from the SEC would like to see more frequent extraordinary event halts from FINRA.
Coulson made one last novel suggestion, one that would please many penny stock traders:
And the final part is, after FINRA does a halt or the SEC does one, it does a suspension, it would be very good to quickly publish to investors what they found. And, you know, FINRA has SRO immunity, we don’t, so we’re a little more careful about what we can put out there. But it would be really good for investors, saying these are the reasons we did it and then let the market have a rehabilitation process to bring something in, how it gets cured, what are the things we need to do.
When the SEC suspends, it publishes a notice that appears among the “Enforcement” pages at its website. If the suspension is for delinquent filings, the reason is obvious, but if it’s for cause, the wording is often opaque. Shareholders in the suspended issue are left frustrated and angry by the lack of explanation. Why not simply satisfy their curiosity? SEC suspension notices are written by the attorney who investigated the case, and over the years, a few of them have chosen to offer fairly specific information. So to make what Coulson suggests policy shouldn’t be difficult. And in fact Michael Paley volunteered that the SEC’s been making an effort to provide additional detail in its suspension orders and notices.
FINRA is even worse where explanations for U3 halts are concerned. No information at all is offered; it announces merely that an extraordinary events halt has been imposed.
Shortly thereafter, the roundtable drew to a close, but not before the head of FINRA’s Investor Education Department, Gerri Walsh, offered her own perspective on retail fraud. She wryly remarked that “if something doesn’t sound too good to be true, then you’re probably dealing with an amateur. Fraudsters are super smart, they’re super slick. And they cause people who fall prey to fraud to buy that dream.”
It’s a good line, but scammers aren’t always smart. What about Frank Ekejija, who claimed to run a fund managing $210 trillion in assets? The SEC wasn’t impressed. The companies he was associated with were suspended, and the investigation into them, their CEO, and Ekejija continues. Penny players aren’t always gullible and trusting. That was far more likely to be the case 20 years ago. Nowadays they’re more apt to call themselves traders than investors, and many more of them pretend to believe whatever story is on sale by the company in question than actually do believe it. What most people think of as the penny stock market is inhabited largely by gamblers. Is that what our capital markets should be? The might be a good subject for another roundtable.
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