What is DTC? Going Public Securities Lawyer
The Depository Trust and Clear Corporation (DTCC), through its subsidiaries, provides clearing, settlement and information services for securities. DTCC operates through 10 subsidiaries – each of which serves a specific segment and risk profile within the securities industry.
DTCC’s subsidiary, the Depository Trust Company (DTC) serves as a custodian of securities deposited by its participants and is the only securities settlement provider in the United States. If an issuer’s securities are DTC eligible, it will hold an inventory of free-trading street name shares on deposit. These free-trading shares are also known as the “public float.”
Issuers must satisfy DTCC’s criteria for their securities to be settled through DTC which results in substantial legal and compliance costs.
How DTC Eligibility Affects Trading
After the purchase of a security occurs, the second portion of the trade transaction occurs. This portion is referred to as clearing. While brokers maintain individual books recording the entire amount of buy and sell orders transacted by their clients, DTC handles clearing of these transactions. Clearing trades involves the matching of the buy and sell orders in a security. Once the transactions are executed, details are sent to DTC, where they are recorded and matched for accuracy. After all the trades are matched for buys and sells, DTC notifies all member firms of their associated obligations, and arranges the transfer of appropriate funds and securities. Thus, individual brokers are not dealing with one another after every trade. Instead DTC serves as an intermediary that facilitates the transfer of stocks and cash. It is important to note that DTC guarantees delivery and if the buyer or seller of the security being cleared through DTC does not deliver the purchase price or security sold, DTC fulfills the obligations of the party that did not deliver.
Typically, the DTC clearing process takes three days to complete. When a security is not DTC eligible clearing occurs only upon physical delivery of the stock certificate representing the security from the seller to the buyer. Clearing without DTC eligibility through physical delivery is not a rapid process – it may take weeks to complete. Without DTC eligibility it is impossible for an issuer to establish liquidity in its securities.
The DTC Eligibility Process
Only participants can request that DTC make a security eligible. The issuer of the securities seeking eligibility must locate an underwriter or other financial institution–sometimes a market maker– that is a DTC Participant and that is willing to sponsor the eligibility process. Participants can submit an eligibility request through the underwriting services of DTC either at the time a security is initially being offered and distributed to the marketplace or at a later time for already issued and outstanding securities.
A transfer/paying agent (the “Agent”) must be appointed for the issuers or the security for which eligibility is being requested, prior to the security being made eligible for DTC services. The applicable Agent must have a completed DTC Operational Arrangements Agent Letter (“Agent Letter”) on file with DTC pursuant to which the Agent agrees to be bound by the terms and conditions of DTC’s Operational Arrangements. The operational arrangements outline the Agent’s obligations to DTC to allow a security to become and remain eligible at DTC. The Agent may also participate in DTC’s Fast Automated Securities Transfer (“FAST”) program which allows transfer agents to eliminate the transfer of equity certificates between themselves and DTC. FAST also allows shareholders opting for direct registration ownership of shares to hold their shares on the books of issuers directly without holding a certificate.
In the case of an eligibility request for an older, already issued and outstanding security, the participant also must present a copy of the physical certificate representing the security and an Agent Attestation form. Further documents and data may be required as part of the eligibility review.
It is the participant that requests eligibility for the securities to establish that the securities satisfy DTC’s criteria. Once DTC has reviewed the submitted information, it may request an opinion of counsel to substantiate the legal basis for eligibility. DTC requires any legal opinion to be provided by an experienced securities attorney who is licensed to practice law in the relevant jurisdiction and is in good standing in any bar to which the securities attorney is admitted. Such counsel must be independent and not in-house counsel or an issuer’s officer or director. Additionally, DTC requires that counsel may not have a beneficial ownership interest in the security for which the opinion is being provided. DTC reserves the right to approve counsel upon whose opinion DTC is being asked to rely.
DTC Eligibility Requirements
DTC’s Operational Arrangements set forth the criteria for an issue to become and remain eligible at DTC. In addition to criteria specified in the Operational Arrangements, requirements include that the securities must be:
i. issued in a transaction registered with the U.S. Securities and Exchange Commission (“SEC”) pursuant to the Securities Act of 1933, as amended (the “Securities Act”); or
ii. issued in a transaction exempt from registration pursuant to a Securities Act exemption, that at the time of the request for DTC eligibility no longer involves transfer or ownership restrictions; or
iii. eligible for resale pursuant to Rule 144A or Regulation S under the Securities Act (and must otherwise meet DTC’s eligibility criteria).
General Document Requirements of DTC for Issuers
Whether at the point of initial offering or when the terms of an already eligible security are amended in a corporate action, underwriting may require the issuer to execute and deliver related documentation to DTC. The following is an overview of the most commonly requested documentation that may be required in order to receive DTC eligibility.
DTC Letters of Representations and Riders Requirements for Book-entry-only Securities
Book-entry-only (“BEO”) securities are securities for which i) physical certificates are not available to investors and ii) DTC, through its nominee, Cede & Co., will hold the entire balance of the offering, either at DTC or through a FAST agent in DTC’s FAST program. Issuers of these securities must submit to DTC a Letter of Representations among the issuer, its Agent and DTC, to DTC prior to an issue being made eligible. An issuer may submit to DTC a Blanket Issuer Letter of Representations, which is issuer specific and applicable to all DTC eligible issuances of or by the same issuer, or an Issuer Letter of Representations, which is specific to a one-time-only issuance.
Additional Requirements of DTC for Certain Securities
Additional riders to the LOR are required for eligibility of many securities. Some common examples where additional riders are required include Rule 144A and Regulation S securities, securities denominated or that have payments in non-U.S. currencies and securities of a U.K. issuer. All relevant CUSIP (or CINS) numbers must be listed on each applicable rider. The rider forms may be obtained from DTC’s website.
Legal Opinions in DTC Matters
As described above, DTC evaluates issues for eligibility on a case-by-case basis and may require the participant seeking to make a security DTC-eligible to provide an opinion from the issuer’s securities attorney regarding the security. Such opinions are typically requested to confirm either: (i) that the SEC registration requirements for that security have been met, or (ii) that the security was exempt from SEC registration by the Securities Act of 1933 under an acceptable exemption and that the security is not subject to transfer restrictions and is freely transferable. Opinions from the issuer’s securities attorney may also be requested in other circumstances, such as when an issuer changes its name or its form of organization in a corporate action and in exchange offers.
DTC and Unregistered Securities
Opinions of counsel with respect to making unregistered securities eligible may be required in connection with the following transactions (among others):
i. securities (either newly issued, those in the secondary market or those issued in connection with corporate actions) that are issued pursuant to an acceptable exemption from SEC registration under the Securities Act; and
ii. the exchange of securities subject to transfer restrictions represented by certificates bearing a restrictive legend for certificates not subject to transfer restrictions with no restrictive legend (e.g., in reliance on the Securities Act Rule 144(b)(1)).
Foreign Issuers and DTC Eligibility
A foreign issuer may be required to make special representations or provide additional legal opinions to protect DTC and its participants from certain risks associated with the laws under which the issuer is organized and/or the laws governing the securities. A foreign legal opinion will refer to relevant laws of the foreign jurisdiction in which the foreign issuer is organized.
Maturity Revisions of Eligible Securities & DTC Eligibility
DTC cannot effect changes on its records to the terms and conditions of an outstanding security without the lawful instruction and proper authorization from the issuer of the respective security. When the maturity of an issue is amended, the issuer must provide DTC with an indemnity letter, which instructs DTC to make relevant changes to the terms and conditions of the affected security, at the time such changes are duly authorized.
DTC Requirements for Rule 144A and Regulation S Securities
To lift restrictions applicable to securities which DTC has initially accepted as eligible pursuant to Rule 144A and/or Regulation S on the grounds that the original restricted and/or distribution compliance period imposed under such exemptions has elapsed, the issuer of the securities must provide an instruction letter to DTC. The instruction letter confirms to DTC that the restricted period and/or distribution compliance period has elapsed and supports the exchange of the formerly restricted securities represented by a restricted CUSIP number for new unrestricted securities of the same issue represented by an unrestricted CUSIP number.
DTC retains the right to deny any issuer the ability to use their depository for any reason at their discretion without notice or explanation to the issuer. For this reason, before an issuer applies for eligibility, it must provide information to DTC concerning the original issue date of its free trading shares, the holders and transferees as well as the specific consideration provided for any free trading shares.
Fast Tracking the DTC Process
Factors that will quicken the DTC process are:
♦ being an SEC reporting issuer and not missing or being late with any reports;
♦ having very few name changes or reverse splits;
♦ the issuer not using service providers that are unscrupulous stock promoters or, lawyers or accountants that have been under SEC investigation or the subject of SEC actions that may have resulted in injunctions, penny stock bars, cease and desist orders, fines and disgorgement or criminal convictions involving securities fraud;
♦ not going public through a reverse merger with a public shell company;
♦ having no record of being involved in a spam campaign, pump and dump scheme, or other fraudulent activities that would raise Anti Money Laundering or Office of Foreign Assets Control issues; and
♦ having no record of unregistered securities sales, especially by affiliates.
The solution for issuers seeking DTC eligibility is for the issuer to file a registration statement under the Securities Act of 1933. Issuers without potential underwriters can register securities in a direct public offering. Issuers expecting to obtain and maintain DTC eligibility need to recognize that it is more difficult if they go public in a reverse merger transaction with a public shell company because of the perceived fraud associated with reverse merger companies. Additionally, they should avoid using the services of securities professionals who have been the subject of SEC investigations and enforcement actions. The key for companies concerned about DTC eligibility is SEC registration.
Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855