Amended Rule 15c-211 Is Only a Week Away – Going Public, Form S-1, Form 211
We last wrote about the Securities and Exchange Commission’s new Rule 15c2-11 in early August. The amended rule was proposed in September 2019; the final rule appeared in September 2020. Now the compliance deadline, September 28, 2021, is only a week away. Penny players holding “no information” stocks hope against hope management will show up and make just enough disclosure to OTC Markets Group to qualify for the bare minimum required by the SEC. That means a single annual report dated within the past 16 months, enough to send the stock in question to OTC Markets’ Pink Limited Information tier.
No one was expecting new developments so late in the day, when Brian Chappatta, a Bloomberg opinion columnist and bond expert, found a joint letter sent to the SEC on August 6 by the Securities Industry and Financial Markets Association (“SIFMA”) and the Bond Dealers of America (“BDA”). The letter points out that “[t]he rule on its face does not distinguish between types of securities, other than municipal securities, which Rule 15c2-11expressly excepts.”
That is: Rule 15c2-11 applies to over-the-counter bonds as well as to over-the-counter stocks. Most fixed income securities—according to the BDA, “virtually all”—trade OTC, and the fixed income securities market is enormous. Michael Decker, the BDA’s senior vice president of federal policy and research, told Chappatta, “Until April of this year, I’ve never paid attention to this rule because this was not a fixed-income rule. The SEC has now taken the position that the rule already applies to fixed income and has always applied.”
Apparently, the SEC has indeed always believed its rule applied to OTC bonds as well as to equities, though in every iteration of the rule itself, the only reference to the latter is the one exempting munis: “The publication or submission of a quotation for a municipal security.” Back in 1998, when the SEC last considered amending Rule 15c2-11, the Bond Market Association (“BMA”) submitted a comment letter dated April 27, 1998. The letter makes the point that the rule, when amended in 1991 and the proposed amendments from seven years later, is focused on equities and specific to microcap securities, also known as penny stocks, because of their vulnerability to fraud. It adds hopefully that “the Association believes that the application of Rule 15c2-11 to these [fixed income] markets was unintended by the Commission and serves no policy objective.”
However, in the section dedicated to questions for commenters in 1998, the SEC dedicated some specific queries to debt securities:
Debt Securities. Rule 15c2-11 covers debt securities, although the Commission recognizes that broker-dealers publishing quotations for debt securities may not have focused on this aspect of the Rule. Debt securities frequently are held by institutional investors, and it does not appear that they have been the subject of the abuses that the Rule is intended to address.
… In light of these considerations, should the Rule continue to apply to debt securities? Should the Rule except all non-convertible debt securities or just non-convertible investment grade debt securities?
The BMA notes in response that the kind of fraud and manipulation that plagues the penny market is not to be found in the fixed income market and believes that is the case because investors in it are “overwhelmingly institutional.” Further, it says:
This is particularly true in the high-yield market, where the surge in issuance under Rule 144A under the Securities Act of 1933 (the “Securities Act”) has barred all but the largest institutions from most new issues. The predominantly institutional nature of investors in the debt market contrasts sharply with the predominantly retail nature of investors in the microcap equity market. Institutional investors have a degree of access to issuers, and information about those issuers, that is on a par with, if not higher than, that of dealers. They do not require the same level of protection that the Commission has instituted in Rule 15c2-11 as do the primarily retail investors in the penny stock and microcap equity markets.
If, however, the Commission insists on applying the rule to fixed income securities, it should at least exempt issuers for which there is substantial information available in the market; debt securities being resold pursuant to Rule 144A; investment-grade and high-yield debt; offshore offerings in reliance on Regulation S; and mortgage-backed and other asset-backed securities.
In a last attempt to persuade, the BMA points out that “[t]he heightened obligations of dealers with respect to issuer information will expose them to increased liability in connection with publishing quotations, which they may choose to avoid by publishing fewer quotations.” It asks that the SEC drop exempt debt securities from the rule.
The Securities Industry Association (“SIA”), which later merged with the Bond Market Association to become SIFMA, sent in its own comment letter the next day, April 28, 1998. As might be expected, it felt that “particularly with regard to many types of debt securities, even the provisions of the existing Rule 15c2-11 appear unnecessary, and the Commission should consider exempting those types of securities from both current and proposed Rule 15c2-11 requirements.” Evidently, the SEC was considering that possibility because the SIA remarks:
The proposal will better achieve its aim if it defines what it considers to be the “microcap” market and applies exclusively to that market. Alternatively, the proposal might exclude unpriced expressions of interest from its coverage. Quotations of other OTC securities should either continue to be treated as they are under current Rule 15c2-11, or should be dropped entirely, as the Commission suggests it might do for debt securities.
In the end, the SEC didn’t have to make up its mind about whether the new rule would regulate fixed income securities because, ultimately, the 1998 amendments were not adopted. It would be more than 20 years before the problem of microcap fraud would once again be addressed through rulemaking rather than by individual enforcement efforts.
The 2019 Amendments
The proposal submitted on September 25, 2019, enjoyed a better reception. Though there was some pushback from individual investors who feared the extremely illiquid stocks they buy and hold would be driven out of the public market, and a few grumbles from broker-dealers and IDQSs (including OTC Markets Group) who believed they should be allowed to charge for submitting Forms 211, until last week it seemed as if most of the problems that needed resolution had been resolved.
Then Chappatta, the Bloomberg columnist, became aware that SIFMA and the Bond Dealers of America were concerned about the possible application of the amended rule to the OTC bond market and published his findings. His article on the subject was picked up by other journalists and reprinted by the Washington Post. Both SIFMA and the BDA had written about the amended Rule 15c2-11 earlier: SIFMA had submitted an ordinary comment letter on December 23, 2019, and the BDA had drafted a letter when the public comment period had been over for more than a year, and sent it, as a draft, to the SEC on May 5, 2021, as the prelude to a meeting to discuss the BDA requests.
It should be noted that this new proposed rule, unlike the one advanced in 1998, mentioned debt securities only once in its questions for commenters, in a section dedicated to what kind of issuers or securities should be excepted from the rule’s provisions:
Are there publications or submissions of quotations for other securities (e.g., debt securities, non-participatory preferred stock, or investment grade asset-backed securities) that have characteristics similar to those of the securities set forth above that should also be excepted from the Rule’s provisions? If so, please explain.
Not a single one of the many commenters responded to that question.
In its letter, SIFMA did not speak to potential issues involving the fixed income markets; at the time, it was only interested in the rule’s impact on penny stocks. The BDA first wrote to the Commission nearly a year and a half later, requesting exemptive relief for bond dealers under Section 36 of the Securities Exchange Act of 1934 (“Securities Act”). Before writing, the BDA had spoken to SEC staff, who had “informally confirmed… that the Rule applies equally to equities and fixed income.”
There were important reasons for the confusion on the part of bond dealers:
Changes to the Rule adopted by the Commission in October 2020 (86 Federal Register 2311) require not only that dealers maintain and review the relevant information but that they also ensure it is publicly available. The SEC’s publication of these changes highlighted the Rule for many fixed income dealers. Before last October, there was a widespread view that Rule 15c2-11 did not apply to quotations in fixed income securities. This view was perhaps fostered by supporting FINRA Rule 6432, “Compliance with the Information Requirements of SEA Rule 15c2-11,” which applies only to “any equity security, other than a Restricted Equity Security, that is not traded on any national securities exchange,” not to fixed income securities (paragraph (e) of Rule 6432).
It is also true that many fixed income dealers did not recognize that the Rule applies to OTC quotations in bonds because it is so obviously written with retail trades in very small-cap equities as its focus. So much of the SEC’s language around the Rule points to penny stocks.
The BDA then set forth a number of statements made in the rule that do not in any way apply to bond trading. Most are on target, but one is inaccurate: “We are aware of no enforcement actions related to pump-and-dump schemes involving fixed income products.” Our firm, on the contrary, knows of a number of penny stock schemes involving fake or real bonds, though they were in no instance the securities the issuer was selling to the public. They were the hook that would persuade retail investors to buy the issuer’s own stock. Enforcement actions were taken in several of those cases.
On a note that is perhaps related, the BDA and SIFMA say in a footnote that “[t]he Commission staff has expressed concerns with the sale of foreign-listed exchange-traded notes to retail investors in the United States. A tailored approach could exclude these types of securities from any exemptive order.”
They go on to point out that although considerable effort was dedicated to calculating the compliance costs of the new rule for equities, “[a]pparently the Commission’s economists did not consider the application of the Rule to fixed income products despite fixed income accounting for more than $1 trillion per day in trading compared to around $2 billion per day in OTC equity trading.” In addition, mortgage-backed securities not guaranteed by a government, and asset-backed securities, would present complex problems, as they’re issued through trusts. Each trust is unique, so each transaction has a different issuer.
There is an exception that would cover certain fixed income securities:
A security with a worldwide average daily trading volume value of at least $100,000 reported during the 60 calendar days immediately before the publication of the quotation of such security; and
The issuer of such security has at least $50 million in total assets and $10 million in shareholders’ equity as reflected in the issuer’s publicly available audited balance sheet issued within six months after the end of its most recent fiscal year.
While the BDA believes the exception probably covers many quotations provided for fixed income trades, it fears the volume requirement may be limiting.
And so the BDA asks that the Commission provide exemptive relief, declaring it’s appropriate because:
It would reflect industry practice that has prevailed for decades. Given that many fixed income firms did not recognize until recently that the Rule applies to fixed income trading, we can assuredly assume that many trillions of dollars of bonds have traded in the last four decades without the application of the Rule and without noted problems or material violations. We are aware of no SEC or FINRA enforcement actions related to firms not applying the Rule to quotations for fixed income products…
Exemptive relief is consistent with the protection of investors because no investors have been harmed by not having applied the Rule to fixed income. The fixed income markets are extraordinarily safe. Of the $47 trillion of non-municipal fixed income securities outstanding at the end of 2020, more than 70 percent is issued or guaranteed by the US government. Of the $10.6 trillion of corporate bonds outstanding, more than 80 percent are rated investment grade with little risk of default.7 The bond market simply is not the high risk, low transparency world of microcap stocks.
All that is likely true. But if so, why did the SEC assure the BDA that Rule 15c2-11 does, and always has, been aimed at the fixed income market as well the microcap market?
They weren’t the only ones who realized bonds with inadequate disclosures might be among the securities targeted by the new rule. In June, TDAmeritrade and Schwab began publishing lists of securities whose issuers “have not made required current financial and company information available to regulators and investors.” The first list contained more than 6,000 items, many of them debt securities. The most recent, which appeared on September 7, features only 1899 items. But there are far more than 6,000 fixed interest securities that trade OTC, so once again, it’s difficult to bring an accurate picture into focus.
The Joint Letter
The letter sent by SIFMA and the BDA to the Commission on August 6 is also a draft. It does not explain whether the expected meeting mentioned in May had taken place or, if it had, whether it brought the parties closer to an agreement.
The joint authors enlarge on a point the BDA had made before: that in 1999, when the amendments to Rule 15c2-11 were reproposed on March 9, the SEC had agreed to “expressly exclude” fixed income securities from the rule, because “[w]e agree that applying the Rule to… certain fixed income debt securities is not directly related to microcap fraud concerns.” Nonetheless, the Commission has yet to make its own current position clear, according to the letter. The authors advance the same theories put forth by the BDA in its earlier request for exemptive relief. Once again, they stress the many fundamental differences between equities sold by OTC issuers, which are largely the same, or at least similar, and a broad range of fixed income instruments. A single issuer may, they say, “sell multiple fixed income instruments with different coupons, different maturities, and different call features. A single asset-backed security offering may be comprised of many tranches with different characteristics and be based on different cashflows.”
Most telling of all, Bloomberg estimates there are about 2.5 million fixed income securities currently outstanding. In comparison to the approximately 10,000 OTC Markets securities in existence, that number is staggering. The BDA is right to say the costs of compliance could be equally staggering. Very few of those fixed income securities trade on a national exchange; the vast majority of debt securities are traded over-the-counter. Another problem is that most bonds trade infrequently. If an OTC security goes four days without a published quotation, it will lose compliance with Rule 15c2-11 and be demoted to the Grey Market. That could happen to a great many fixed income securities if the SEC offers no exception to the rule.
Paradoxically, applying the rule to fixed income securities could make for less transparency and liquidity, resulting in, the BDA says, “wider bid-offer spreads, wider spreads to benchmarks, increased cost of issuing debt, increased costs of price discovery, and less efficient markets.”
The BDA and SIFMA are aware of the serious fraud problems that plague the OTC Markets. But they don’t see the same thing happening in the fixed income markets and believe that if it ain’t broke, it shouldn’t be fixed. Based on their arguments, they once again ask the SEC for an exemptive order excepting “any security that is a debt security and any non-convertible preferred stock, collectively to be referred to as “fixed income securities,” from compliance with Rule 15c2-11. If the Commission is unwilling to do that, they request that it delay implementation of the new rule “until such time that a cost-benefit analysis… to fixed income securities is completed and published for comment as part of the standard rule amendment process, to determine whether a specific subset of fixed income securities can be identified as suitable for coverage by the rule.”
That last would take six months, at best, perhaps longer. It’d doubtful the SEC would be happy with more delays. After all, the rule was proposed in 2019. Yet the authors say in closing that they’re “willing and open to continued discussions with the Commission” about what they see as a problem. It doesn’t seem as if the Commission feels any urgency about the matter, and yet the deadline’s only a week away. It looks as if the new rule may offer some surprises up till the very last minute.
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 [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.