DTC Proposes Procedures For DTC Chills and Global Locks
The Depository Trust Company is a subsidiary of The Depository Trust & Clearing Corporation (“DTCC”), and is the central securities depository in the U.S. The SEC, the Federal Reserve System and the New York State Department of Financial Services regulate DTC.
In certain circumstances, a DTC Chill or a Global Lock on a company’s securities. As a result, they will trade with difficulty, or not at all. The number of Chills and Locks has increased in recent years, and more and more issuers have been faced with the task of trying to get them lifted. That has often proved difficult, if not impossible.
DTC has proposed new procedures to the Securities and Exchange Commission (“SEC”) for issuers whose securities may be subject to DTC Chills and Global locks.
They are designed to prevent the imposition of these sanctions, and to set conditions for their removal should they be imposed.
Their purpose is to ensure compliance with the SEC’s registration provisions and impose specific procedures when the securities of shell companies used in reverse merger transactions are deposited with DTC. The new initiative demonstrates that DTC is the new watchdog for issuers who do not comply with the SEC’s registration provisions. A common characteristic of reverse merger issuers involves the issuance and transfer of free trading securities in violation of the registration provisions.
How DTC Monitors Securities
DTC is responsible for clearance and settlement of securities transactions that are eligible for its depository and book-entry transfer services. When securities are “free trading shares” they are deposited at DTC in the name of CEDE and Co.
As part of DTC’s routine monitoring of securities transactions, it identifies large deposits of thinly traded, low- priced free trading securities. Such deposits are often indicators of potential illegal distributions. If DTC determines that securities deposited at DTC are not lawfully free trading, it may impose a DTC Deposit Chill which prevents further deposits of free trading shares of that particular issuer.
Getting a DTC or Global Lock Removed
In order to have the DTC Deposit Chill removed, the issuer must demonstrate that DTC that the securities are free trading. If DTC determines there is “definitive evidence” that improperly free trading shares have been deposited, it may impose a Global Lock. In this context, “definitive evidence” typically means that the SEC or another regulatory or law enforcement agency has brought an enforcement action alleging that the securities are restricted and not lawfully free trading. These types of actions are common after reverse merger transactions with public shell companies.
DTC Book Entry Requirements
DTC accepts deposits of securities that meet its eligibility requirements for book-entry services from its DTC Participants. DTC’s eligibility standards include that the securities in the public float have been distributed in compliance with Section 5 of the Securities Act of 1933, in a manner that does not impose ownership or transfer restrictions, so that the securities are freely transferable. This means that the securities were offered pursuant to an effective registration statement filed with the SEC or pursuant to an exemption from registration that does not impose ownership or transfer restrictions. Securities must meet these standards to be eligible for DTC’s book-entry services.
DTC’s Restrictions for Improperly Issued Free Trading Shares
If DTC has reason to believe that securities deposited with DTC are not properly free trading, it may restrict services to the securities pending the issuer establishing that the securities are freely transferrable. These restrictions typically are: (i) not accepting additional deposits of these securities (a “Deposit Chill”), or (ii) it may cease to provide any book-entry services with respect to these securities (a “Global Lock”).
DTC’s Proposals
DTC’s proposed rules will formalize the process for issuers to receive notices of restrictions and to have their objections heard. The process will work as follows:
♦ Issuers will be notified in writing of any service restriction;
♦ Issuers will have reasonable time frames in which to respond;
♦ Issuers will have clear guidelines to support a release or prevent restrictions;
♦ DTC will respond to issuers within stated time frames;
♦Throughout the notice and review process, DTC and its counsel will be available to consult with issuers and their counsel regarding compliance with these requirements.
DTC Chills
DTC may impose a Deposit Chill if it detects large-share deposit activity in a thinly traded, low-priced security, because this activity is a recognized red flag for distributions of securities in violation of Section 5 of the Securities Act of 1933.
Issuer Notification of Deposit Chill
DTC will provide the issuer with written notice of the Deposit Chill by overnight courier. DTC will send the notice no later than twenty business days prior to the imposition of the Deposit Chill or, if the Deposit Chill is imposed prior to giving notice, no later than three business days after the Deposit Chill is imposed. DTC will impose a Deposit Chill prior to notice where there is a threat of imminent harm or injury to DTC or the industry, including if circumstances suggest that advance notice might accelerate improper deposits. If DTC acts prior to notice, the issuer will have the opportunity to show that there is no meaningful risk of imminent harm or injury.
The Deposit Chill notice will require, among other things, that the issuer submit a legal opinion from its independent outside counsel. The opinion must confirm that the affected securities are freely transferable and address such other matters of concern as DTC may identify. To guide the issuer, DTC typically provides a template legal opinion. DTC and its counsel are available to an issuer and its counsel to discuss the opinion and related issues.
DTC Review of Issuer Response to the Deposit Chill Notice
DTC will respond in writing to the issuer’s response to the Deposit Chill notice within twenty business days or, if the Deposit Chill has been imposed prior to notice, within ten business days.
An officer of DTC who played no role in the Deposit Chill decision will decide whether the issuer’s response satisfactorily addresses transferability and any other matters requested. The officer may consult with counsel regarding the review. DTC will contact the issuer within the response time frame if further information or clarification seems warranted, and provide the issuer ten additional business days to respond.
Determination
If the DTC officer determines that the issuer’s response reasonably establishes that the securities are freely transferable and not otherwise impaired, DTC will promptly lift the Deposit Chill or, in notice-first cases, DTC will not impose the Deposit Chill.
If the issuer fails to respond within twenty business days (or any extended period) or if the DTC officer finds that the response does not satisfy the requirements, the Deposit Chill will continue and DTC may impose a Global Lock. Before doing so, DTC will give the issuer an additional ten business days for a supplemental response; issuers should bear in mind that the supplemental response will be limited to proving the original response was properly submitted within the required time frame or that DTC made a clerical mistake in review of the original response. The supplement will not be an opportunity to begin the review process again.
The proposed rules impose strict deadlines on both issuers and DTC. The proposal also gives DTC the discretion to lift or modify a Deposit Chill if it reasonably believes that it is in the best interest of DTC and its participants.
Global Locks
DTC may impose a Global Lock, which suspends both deposits and book-entry transfers of a security, as well as withdrawals and physical deliveries of the security, based on legal actions commenced by government or law enforcement authorities, most typically the SEC. Additionally, DTC will impose a Global Lock if an issuer fails to satisfy the requirements for lifting a Deposit Chill.
Issuer Notification of Global Lock
DTC will provide the issuer with written notice of the Global Lock via overnight courier. DTC will send the notice no later than twenty business days prior to the imposition of the Global Lock or, if the Global Lock is imposed prior to giving notice, no later than three business days after the Global Lock is imposed. DTC will impose a Global Lock prior to notice where there is a threat of imminent harm or injury to DTC or the industry. This would include situations where the SEC has alleged that the defendants in a civil or criminal action are in possession of additional unregistered shares that they could deposit into the DTC system. If DTC acts prior to notice, the issuer will have the opportunity to show that there is no meaningful risk of imminent harm or injury.
The Global Lock notice will, among other things, include the reason for the Global Lock and identify the regulatory or law enforcement proceeding upon which the restriction is based. It will note the date the restriction was or will be imposed, and that the issuer has twenty business days to respond, although DTC may provide a twenty-business-day extension for good cause.
The Global Lock notice will afford the issuer the opportunity to demonstrate that the securities deposited at DTC were not the subject of the legal proceeding on which DTC based its restriction. The issuer will also have the opportunity to demonstrate that the proceeding has been withdrawn, dismissed, or otherwise resolved in favor of the defendant that deposited the securities at DTC. Otherwise, DTC will restrict the securities, based on the allegations in the pleadings.
DTC Review of Issuer Response to the Global Lock Notice
DTC will respond in writing to the issuer’s response to the Global Lock notice within twenty business days or, if the Global Lock has been imposed prior to notice, within ten business days.
Where DTC bases a Global Lock on allegations in an SEC enforcement action or other regulatory or law enforcement proceeding, DTC’s review is necessarily limited. It will not provide the issuer with an alternative forum in which to litigate the issues pending before a court or administrative agency.
Where a Global Lock results from the issuer’s failure to satisfy DTC’s eligibility concerns that led to Deposit Chill, the procedure for releasing the Lock is described below.
Determination
If DTC determines that the issuer’s Global Lock response satisfies the conditions set forth in the Global Lock notice, DTC will release or not impose the Global Lock. Otherwise, DTC will impose the Global Lock or maintain one previously imposed.
Procedures For Removing Restrictions
DTC’s proposed rule will also seek SEC approval to reinstate full services under the following circumstances.
Under the Safe Harbor provision of Securities Act Rule 144, restricted securities may become freely transferable after a specified holding period has elapsed. Because securities that have been Globally Locked have been credited to participant accounts without transfer during the period of the Global Lock, DTC is proposing, by analogy to Rule 144, to release Global Locks after the following periods have elapsed:
If the Global Lock is the result of a judicial action or administrative proceeding alleging that the issuer’s shares had been distributed in violation of Section 5 of the Securities Act:
DTC may lift the Global Lock one-year after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any defendant that deposited the securities at DTC. This one-year approach applies to issuers that are not SEC reporting companies, DTC may lift the Global Lock six-months after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any such defendant. This six-month approach applies to issuers that are SEC reporting companies. In the case of SEC-filers, DTC may lift the Global Lock six-months after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any such defendant.
If the Global Lock is the result of an issuer’s failure to respond or to respond adequately to a Deposit Chill notice:
DTC may lift the Global Lock one year after the date it was imposed for issuers that are not SEC reporting companies, and after six months for issuers that are SEC reporting companies.
The release of a Global Lock under these circumstances would only be available to an issuer that is not, and never has been, a “shell company” as defined in Securities Act Rule 144(i), unless the issuer had ceased to be a shell company and filed the specified disclosures required by this rule to no longer be deemed a shell company. If new facts come to light during the six-month or one-year period that call into question whether the securities satisfy DTC’s eligibility requirements, DTC may not release the Global Lock (subject to the fair procedures discussed above.)
When approved by the SEC, the new DTC proposals will eliminate most of the confusion surrounding the imposition of Chills and Global Locks, and will make it easier for issuers to avoid them, or to see to their removal once imposed.
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 and compliance 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.
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Brenda Hamilton, Securities Attorney
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