OTC Markets Policies on Section 17(b) and Stock Promotion

The SEC and Section 17(b) Stock Promotion
The SEC and Section 17(b) Stock Promotion

In the over-the-counter equities market, paid stock promotion has long been of concern to the Securities and Exchange Commission (“SEC”) and to responsible market participants.  Recently the OTC Markets has taken an interest in the rules that apply to investor activities  and promotion of the issuers on their platform. Stock Promotion isn’t just a way of attracting attention to a company and its stock; it can also be a form of illegal stock manipulation.  That is because nearly all stock  promotions are financed by individuals or entities that hold large securities positions acquired at negligible cost or at a considerable discount to market price, who want to sell their shares for a hefty profit.  Those people may be former insiders, current insiders concealing the amount of their ownership, stock promoters paid in shares or toxic funders who lent money to the issuer in exchange for convertible notes.

The schemes in which they participate are called pump and dump operations.  Stock promoters use various means at their disposal—email blasts, phony “research reports” posted on a variety of websites, social media chatter talking up the “hidden gem” in question, and, even today, boiler rooms whose staff cold calls likely prospects—to send a stock skyward. Sometimes management is in on the play, and helps it along by issuing an avalanche of press releases touting the company’s accomplishments and imaginary future projects.  The plan may be even more elaborate.  A group of unscrupulous individuals will purchase a shell company, or even create one from scratch, and spend a year or more setting it up as a vehicle for a pump and dump.  When the time is ripe, the pump will begin.

Then comes the dump.  As soon as the promoters get to work, the shareholders who commissioned the operation begin to sell their shares into the pump.  At first, the price may continue to rise, sometimes dramatically, but sooner or later the selling takes its toll, and as stock price slides, a rush for the exits begins.  Unwary retail investors will be caught holding stock they purchased for much more than it’s currently worth.

OTC Markets Group’s Efforts to Curtail Stock Fraudulent Promotion

While promoting a stock isn’t illegal as long as required disclosures are made, in reality most promotions are manipulative and therefore violations of the securities laws.  In the past six to eight years, the SEC has dedicated considerable effort to curtailing the activities of some of the biggest promotional groups, but its success has been mixed.  Some stock promoters have gone underground, directing operations from the shadows and hiring social media amateurs and semi-pros to do the actual pumping.  Others have moved outside the United States, where they’re harder to catch.  But there are still insiders who want to profit on their large holdings, and toxic funders who, despite the SEC’s attempts to make conversions and deposits more difficult, have every intention of dumping their own enormous quantities of stock.  Both of these groups are particularly reliant on stock promoters because they need big volume in order to realize their profits. The stocks in question aren’t reliably liquid, and a great deal of liquidity is needed to sustain sales of hundreds of millions of shares.

As early as April 2006, when OTC Markets Group was still called Pink Sheets, it submitted a “Petition for Commission Action to Protect the Investing Public from Unlawful and Deceptive Securities Promotions” to the SEC.  Its proposal was simple and straightforward:  it asked the SEC to promulgate a new rule under Sections 5 and 17 of the Securities Act of 1933 to prevent “unlawful and deceptive activities by stock promoters and their sponsors.”  The proposed rule would provide that:

  • Promotional materials must identify promoters and their sponsors, and the nature and amount of consideration paid for the promotion.
  • Adequate current information regarding the issuer must be publicly available at the time the promotion takes place.
  • Stock held by stock promoters and their sponsors at the time the promotion takes place is restricted and cannot be sold without registration or an appropriate exemption.
  • Stock promoters must provide issuers of the stock subject to the promotion with a copy of the promotional materials, and promoters, their sponsors and issuers must inform transfer agents and broker-dealers that stock registered to or held on behalf of promoters and their sponsors is restricted.

In the petition, OTC Markets went on to explain that investors needed protection from the flood of spam promotional emails they were receiving from sources that often failed to identify themselves in any meaningful way, and also failed to offer any verifiable information about the stock or stocks they were touting.  Before the advent of the electronic age, the reach of promoters was limited.  They could mail “tip sheets” to members of the public, at least some of whom had signed up for them; they could buy mailing lists and create colorful and costly mailers to lure the unsuspecting; or they could use boiler rooms to cold call prospective victims.  But email revolutionized the game.  With the press of a key, millions of people could be made aware of a promoter’s hot new “pick.”  If even a small percentage of them decided to take a flutter in the stock, volume, and probably price as well, would rise.

Not at all unreasonably, OTC Markets believed the SEC could and should do more to control and rein in spam and fraudulent promotions.  While pump and dump schemes are already illegal because they constitute market manipulation, the new proposed rule would provide greater clarity about what is and is not illegal, and would mandate increased disclosures, increasing transparency.

The SEC did not adopt the OTCMarkets’ proposals.

Section 17 of the Securities Act

Both unscrupulous and careless stock promoters and their sponsors can be found in violation of Section 10(b) of the Securities Exchange Act of 1934, a general anti-fraud provision that makes it unlawful to “use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the  SEC may prescribe as necessary or appropriate in the public interest or for the protection of investors.”

Section 10(b) casts a wide net, and is used in a great many enforcement actions.  Section 17 of the Securities Act has more direct application to securities promoters and their activities.  Section 17(a), like Section 10(b), is a general anti-fraud provision:

It shall be unlawful for any person in the offer or sale of any securities… directly or indirectly— 

  • to employ any device, scheme, or artifice to defraud, or 
  • to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light       of the circumstances under which they were made, not misleading; or 
  • to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Most penny stock promotions deal in unverified and unsupported information that is precisely designed to mislead and deceive investors.  Section 17(b) is specifically directed at stock promotion and promoters:

It shall be unlawful for any person, by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.

While the provisions of Section 17(b) are known to and understood by nearly all professional promoters, they’re often disregarded.  Countless SEC enforcement actions have shown that while most touts do disclose the fact that they’re compensated, and state the kind and amount of that compensation, they’re often untruthful about its value.  Some make confusing disclosures involving a “total budget”; others report only what they “expect” to be paid.

SEC v. Recycle Tech, Inc., an interesting SEC enforcement action from 2012, illustrates how Section 17(b) is applied, and what obligations it imposes on promoters.  In its complaint, the SEC charged Kevin Sepe, Ronny J. Halperin, Ryan Gonzalez, OTC Solutions LLC, Anthony Thompson, Pudong LLC, Jay Fung, and securities lawyer, David Rees in connection with a pump and dump scheme conceived and executed in 2010.  Sepe was the mastermind, his old friend Halperin lent a hand, and his nephew’s friend Gonzalez played the part of Recycle Tech’s CEO and president.  Thompson and Fung were the promoters.  OTC Solutions was Thompson’s company; Pudong was Fung’s.  David Rees was the Company’s securities lawyer.

The premise for the scam was simple.  In the wake of the earthquake that hit Haiti in January 2010, there was desperate need for housing for victims of the disaster.  Within weeks of the event, Gonzalez incorporated a fake company called Green Building Engineering & Contractors, LLC.  Green Building claimed to be in the business of “converting river barges into cost-effective, eco-friendly, hurricane-and-seismic-resistant, mobile shelters, ready to be shipped anywhere in the world.”  It was quickly merged into the Recycle Tech public shell.  Rees wrote opinion letters declaring that Recycle Tech’s debt could be converted into unrestricted stock, and the stage was set.  With the help of seven false and misleading press releases and vigorous pumping by Fung and Thompson, the stock took off.

By the time the SEC filed its complaint, Sepe, Halperin, and Rees had settled the charges, and final judgments had been entered against them.  The only remaining defendants were Thompson, Fung, the companies they owned and operated, and Gonzalez.

The SEC alleged that the two promoters had violated Sections 17(a) and 17(b) of the Securities Act.  As to Fung, the agency noted that his newsletter Pennypic offered only a generic stock scalping disclaimer:

[w]hen Pennypic.com receives free trading shares as compensation for a profiled company, Pennypic.com may sell part or all of any such shares during the period in which Pennypic.com is performing such services.” It then specifically disclosed that it “has received from a third party non affiliate 2.325 million free trading shares of [Recycle Tech] for advertising and marketing.

It noted specifically that “[t]he newsletter did not, however, disclose the third party’s identity or Fung’s Recycle Tech stock sales.”  The “third party” was, the SEC had learned, Kevin Sepe.

Jay Fung Objects

Fung and his attorneys believed that Section 17(b) did not require disclosure of parties who pay for stock promotions.  In a motion to dismiss the SEC’s complaint filed on August 31, 2012, Fung and Pudong argued that

none of the allegations assert that Defendants knew or should have known that (1) the press releases issued by the company were false or inaccurate, (2) that the opinion letter(s) provided to Defendants reflecting that the shares were free trading were incorrect, and (3) Defendants Sepe or Halperin were affiliated with, or control persons of, the Company. Moreover, the incessant hyperbole utilized by the Commission in labeling the newsetters [sic] as “touting” or “promoting” or “hyping,” does not mean that they were violative of the federal securities laws.

In other words, Fung was just doing his job, and in no way violated Section 17(a).  He disclosed that he owned 2.325 million unrestricted shares of Recycle Tech, and announced that he “may sell part or all of any such shares” during the time the promotion, which he called “advertising and marketing services” was underway.  Moreover, Fung pointed out that nothing in the wording of Section 17(b) suggests that an individual who receives compensation for publishing information about a stock or its issuer must identify the source of that compensation.  Fung said only that he was paid by a “third party,” and that was all he needed to say.

On September 26, 2013, Judge Joan Lenard handed down an order granting in part and denying in part Fung and Pudong’s motion to dismiss.  Lenard notes that Fung had received his 2.325 million shares from Sepe on February 23, 2010.  Though he said in Pennypic that he “might” sell all or any of those shares while the promotion was underway, he in in fact dumped them all on the day he received them, for $456,457.  The judge saw that as proof of “misrepresentations and omissions” in Fung’s disclosure, because he planned to sell his shares immediately after publishing his profile of Recycle Tech in Pennypic.  Citing SEC v. Blavin, she added that courts have held “a disclaimer that the investment advisor ‘may’ trade in recommended securities for its own account is itself a material misstatement.”

Further, the misrepresentations in question were made, as Rule 10b-5 requires, “in connection with the offer, sale, or purchase of securities.”  Fung’s newsletter promoted the purchase of Recycle Tech securities, of which he owned a considerable number.  His promotion inflated the price of that stock, which made his failure to disclose his intent to sell immediately, or the identity of the third party who gave him the stock, a material misrepresentation made “in connection with” the offer, sale, or purchase of securities.  For that and other reasons, Judge Lenard upheld the SEC’s charges of violations of Section 17(a).

That said, the Court was not convinced by the SEC’s allegations concerning Section 17(b) violations, because although material misrepresentations or misleading omissions are 17(a) violations, they are not relevant to 17(b), whose purpose is to ensure that readers of publications like Pennypic are aware that the material in question is not unbiased, but provided for compensation.  And so Judge Lenard dismissed the charges relative to Section 17(b).   In the end, Fung was ordered to pay disgorgement and a civil penalty in the amount of $607,455.36, was enjoined from violating Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act.

Had Pink Sheets’ 2006 recommendations been adopted by the SEC, Fung could not have violated Section 17(a) in the way he did, because his stock would have been restricted, and he’d have been unable to sell it so quickly.  He would in addition have been required to name the individual or entity that paid him for the stock promotion.  His story didn’t end with Recycle Tech; he was sued by the SEC several times more, and in 2018 was sentenced to a brief term in prison for his involvement in an insider trading scheme.

OTC Markets Group’s Recent Initiatives to Combat Illegal Promotions

Nowadays, stock promoters are rarely charged with Section 17(b) violations, because professional promoters know they need to make the disclosures it requires.  Amateur stock touts are another story when it comes to stock promotion.  In November 2018, the SEC announced settled actions against boxer Floyd Mayweather Jr. and music producer DJ Khaled in connection with Initial Coin Offerings (ICOs).  Mayweather posted about the ICOs on his Instagram, Twitter, and Facebook accounts, and was paid $300,000 for his trouble.  Khaled received a more modest $50,000 for promoting only one ICO on his Twitter and instgram accounts.  Neither man made any disclosure of the payments, and both were charged only with Section 17(b) violations.  There are no doubt many more compensated social media amateur touts who violate 17(b) on a regular basis, but they aren’t famous, and so far, they’ve received no attention from regulators.

OTC Markets, however, has persisted in its attempts to alert investors to issuers subject to stock promotion.  At its website, it offers information about its Policy on Stock Promotion, seeking not only to educate investors about how promotions work, but also to explain how it responds to promotions it detects.

First of all, it will place a “stock promotion” flag next to the ticker of the stock and company information at its website, a policy initiated in March 2018.  The flag will remain in place until 15 days after the last promotional material appears.  OTC Markets may also ask the company whose stock is being promoted to issue a press release confirming the information being promoted, or identifying it as misleading.  The company may also be asked to make corrections to promoted claims and to disclose any recent transactions by insiders and affiliates.  If OTC Markets’ analysts see reason to do so, they may request transfer agent records and additional disclosure about share issuances and financing agreements, as well as the identities of the people and advisers associated with those transactions.  It also provides a “best practices” guide to help issuers avoid fraudulent stock promotions and problematic associations that can lead to trouble in the future.

Companies with a history of stock promotion may not qualify for trading on the OTC Markets OTCQX or OTCQB tiers, and may be removed from those tiers if OTC Markets detects a manipulative promotion that may have a “potentially negative impact on the integrity of the market.”  When deemed necessary, a Caveat Emptor designation will be attached to a promoted stock.  It will not be removed until the company can demonstrate there’s no longer a public interest concern.  Typically, the designation will not be removed for at least 30 days, and unless the issuer qualifies Pink Current Information status, its quotes will be blocked at the OTC Markets website.

Issuers should also be aware that OTC Markets makes referrals concerning stock promotions to the SEC, FINRA and other regulators.

In the past eight years or so, the SEC has brought a considerable number of enforcement actions involving high-profile stock promotions whose email blasts were once eagerly awaited and whose newsletters were once avidly followed by traders hoping to make a quick, and satisfyingly large, profit.  Some of those involved in those stock promtions faced not only civil lawsuits but also criminal prosecutions brought by the Department of Justice.  That has caused alarm in the world of shady insiders, toxic funders, and the stock promoters themselves.  But stock promotion is a big business, and new avenues will be explored who aspire to get into the promotion game.  Right now, the focus is on social media plays.  They’re less disciplined, and for the most part less effective, than the professional jobs of yesteryear, but they can deliver big volume, and that’s all the toxic funders and, in some cases, conniving insiders need.

It’s to be hoped that the SEC, FINRA, and OTC Markets are also exploring new avenues, and will develop new ways to deal with this old but ever-changing threat.

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.

Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
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Boca Raton, Florida 33432
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