SEC Seeks Comment On DTC Proposals
On December 18, 2013, the SEC published a notice to solicit comments concerning The Depository Trust Company’s (“DTC”) proposals to specify procedures for securities deposited at DTC for book entry services when it imposes or intends to impose restrictions on the further deposit and/or book entry transfer of those securities.
DTC’s proposed rules establish procedures for: (a) notice to an issuer that a Deposit Chill or Global Lock will be imposed, (b) an explanation of the specific grounds upon which the restrictions are being or have been imposed, (c) the actions that the issuer must take in order to prevent or remove the restriction, (d) the process DTC will undertake to review written submissions of the issuer and to render a final decision concerning the restriction, and (e) maintenance of a complete record for submission to the Commission in the event an issuer appeals.
The proposed rule change is in accordance with Section 17A(b)(5)(B) of the Act and encompasses a uniform procedure for issuers whose securities may be or are subject to a Deposit Chill or Global Lock.
Overview of the Role of DTC
DTC is the nation’s central securities depository, registered as a clearing agency under Section 17A of the Securities and Exchange Act of 1934 (“Exchange Act”). DTC performs services and maintains securities accounts for its participants, primarily banks and broker dealers (“Participants”). Among other things, a Participant may present a Security to be made eligible for DTC’s depository and book-entry services and, if the Security is accepted by DTC as eligible for those services and is deposited with DTC for credit to the securities account of a Participant, it becomes an “Eligible Security”.
Thereafter, other Participants may deposit that Eligible Security into their respective DTC accounts. Once the Eligible Security is credited to the account of one or more Participants, interests in that Eligible Security may be transferred among Participants by book-entry in accordance with the DTC Rules and Procedures. As provided in the DTC Rules and Procedures, DTC processes the transfer of interests in Eligible Securities among DTC Participants by credits and debits to Participant accounts in accordance with the instructions of delivering and receiving Participants who are parties to the transaction. To facilitate book-entry transfer and other services that DTC provides for its Participants with respect to Deposited Securities, Eligible Securities are registered on the books of the issuer (typically, in a register maintained by a transfer agent) in DTC’s nominee name, Cede & Co. Eligible Securities of an issue deposited at DTC are maintained in “fungible bulk;” i.e., each Participant to whose DTC account securities of that issue have been credited has a pro rata (proportionate) interest in DTC’s entire inventory of that issue, but none of the securities on deposit is identifiable to or “owned” by any particular Participant. DTC has the ability to determine whether to accept a security as an Eligible Security and when an Eligible Security will cease to be such. DTC can also limit its services to particular Eligible Securities.
Generally, securities that may be made eligible for DTC’s book-entry delivery, settlement and depository services are those that have been issued in a transaction that: (i) has been registered on a registration statement filed with the SEC pursuant to the Securities Act of 1933 (“Securities Act”); (ii) was exempt from registration pursuant to a Securities Act exemption that does not involve (or, at the time of the request for eligibility no longer involves) transfer or ownership restrictions; or (iii) permits resale of the securities pursuant to Rule 144A or Regulation S and in all cases such securities otherwise meet DTC’s eligibility criteria. Thus, an essential element of DTC eligibility is that the securities are “freely tradable”.
DTC may require an issuer to provide an opinion from a securities attorney in order “to substantiate the legal basis for eligibility.” In other words, the attorney will opine that the securities are lawfully free trading. DTC maintains an effective system for monitoring compliance. When this monitoring raises concerns as to whether securities held at DTC have been distributed in violation of federal law including, without limitation, the requirements of Section 5 of the Securities Act, DTC may impose a Deposit Chill or Global Lock. Typically this occurs under two scenarios.
Deposit Chills l Large Volume Deposits of Free Trading Securities
Large volumes of deposits of unregistered free trading shares of penny stocks have been identified by the SEC and FINRA as a “red flag” for possible unlawful distribution of securities. Additionally, the federal Financial Crimes Enforcement Network (“FinCen”), has similarly recognized that “substantial deposit, transfer or journal of very low-priced and thinly traded securities” triggers anti-money laundering concerns.
When DTC detects large blocks of penny stock deposits and its monitoring suggests that it may not be freely-tradable, it imposes a Deposit Chill on that issue. The Deposit Chill blocks the deposit of further securities of the issue, although other services, including book-entry transfer movements, continue to be provided with respect to the Eligible Securities deposited at DTC before the Deposit Chill. If an issuer fails to respond to a notice of a Deposit Chill as required, or if DTC determines that the response is insufficient to establish that the deposited securities satisfy DTC’s eligibility requirements, a Global Lock will be instituted. In these circumstances, an issuer will be given notice of the impending Global Lock and an opportunity to demonstrate that a response to the Deposit Chill notice had, in fact, been submitted or that in reviewing the response, DTC had made a clerical mistake or oversight.
Global Locks l Enforcement Proceedings
When DTC becomes aware of a law-enforcement or regulatory proceeding alleging violations of federal law or regulations (an “Enforcement Proceeding”), particularly those alleging any violation of Section 5 of the Securities Act, relating to securities of an issue on deposit at DTC, DTC imposes a Global Lock on that issue. A Global Lock prevents additional deposits and restricts all book-entry and related depository services with respect to the issue.
The Proposals
DTC’s proposed Rules 22(A) and (B) address the procedures by which it gives affected issuers notice of Chills and Global Locks. The procedures are designed to enable issuers to object to a Deposit Chill or Global Lock prior to imposition of the restriction by DTC or to cause DTC to release Deposit Chills and Global Locks imposed without such prior notice or at any time during the continuance of any such restriction.
DTC Deposit Chill Proposals
In order to challenge a Deposit Chill, proposed Rule 22(A) provides the affected issuer with the opportunity to establish that the issue meets DTC’s eligibility requirements, including by submitting a legal opinion from an independent securities attorney establishing that the securities deposited at DTC are freely tradable. DTC’s reliance on legal opinions of securities attorneys for this purpose is authorized by DTC’s Operational Arrangements. If the issuer successfully demonstrates that the deposited securities continue to satisfy DTC’s eligibility requirements, DTC would not impose the Deposit Chill or, if already in effect, would release it.
Global Lock Proposals
In order to challenge a Global Lock, proposed Rule 22(B)(2)(b) provides the affected issuer with the opportunity to establish that (i) DTC has made a mistake in associating the issuer’s Eligible Securities with the specified Enforcement Proceeding or (ii) that the Enforcement Proceeding has been has been withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the defendants allegedly responsible for the alleged violations of Section 5 of the Securities Act relating to the Eligible Securities. If the issuer successfully demonstrates either factor, DTC would not impose the Global Lock or, if already in effect, DTC would release it.
Otherwise, proposed Rule 22(B)(3) provides that DTC will release a Global Lock within either one year or six months, as the case may be, after the final disposition of the Enforcement Proceeding with respect to those defendants alleged to have been responsible for the illegal distribution of the Eligible Securities that were subject to the Global Lock.
Similarly, pursuant to proposed Rule 22(B)(4), where a Global Lock has been imposed because an issuer has failed to satisfy DTC’s concerns that led to a Deposit Chill, the one year/six month waiting period also applies, but runs from the date of the imposition of the Global Lock. The proposed standard to release a DTC Deposit Chill or Global Lock after the passage of six months or one year (from the appropriate starting date) was developed by analogy to the safe harbor provision of the Securities Act, Rule 144, which, under certain circumstances, permits the unregistered resale of restricted securities (as defined under paragraph (a)(3) of the Rule) after expiration of the relevant holding period. However, the foregoing will not apply to an issuer that is, or was, a shell company as defined in Rule 144(i)(1), unless the issuer has filed the specified disclosure required by Rule 144(i)(2).
Section 17A(b)(3) and (5)
Section 17A requires a registered clearing agency that denies or limits access to the agency’s services to employ “fair procedures.” These procedures require the clearing agency to give the person notice and an opportunity to address the specific grounds for denial or prohibition or limitation and to keep a record.
Proposed Rule 22(A)
Section 1 provides that Rule 22(A) sets forth the fair procedures available to issuers where DTC intends to impose or has imposed a Deposit Chill as a result of DTC having detected large volume deposits with respect to the issuer’s Eligible Securities.
Section 2 provides that issuers will be given twenty business days’ advance notice that DTC intends to impose a Deposit Chill or, if DTC reasonably determines that it is faced with, among other things, imminent harm, injury or other such consequence, to DTC or its Participants, or where the Corporation otherwise reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through the Corporation, whether or not such circumstances are otherwise specified by Rule22(A), notice will be given within three business days after the Deposit Chill has been imposed. Section 2(a) sets forth the issuer’s right to contest the action by submitting a response to the notice and the time frame for doing so.
Section 2(b) requires, consistent with DTC’s Operational Arrangements, that the issuer support the response with a legal opinion, prepared by an independent securities attorney, confirming that the issuer’s securities deposited at DTC satisfy DTC’s eligibility requirements. As guidance for the issuer and its counsel, DTC will provide a template legal opinion.
Section 2(b)(i) provides that, in response to the Deposit Chill Response, DTC may present the issuer with a request for additional information (the “Additional Request”), to which the issuer shall submit a response (the “Additional Response”) which shall not be less than 10 business days from the date of the Additional Request. Section 2(c) establishes the time frame in which DTC will provide the issuer with a written decision in connection with the issuer’s timely response to notice of the Deposit Chill. Specifically, DTC will provide each issuer that submits a Deposit Chill Response or Additional Response with a written decision within twenty business days after DTC receives the Deposit Chill Response or the Additional Response or, in the case of a Deposit Chill imposed before issuance of the Deposit Chill Notice, within ten business days after receipt by DTC of the Deposit Chill Response or Additional Response.
Section 2(c) also provides that if the issuer does not submit a response to the notice or does not do so in a timely matter, or if DTC reasonably determines that the response does not establish that the issuer’s securities on deposit at DTC satisfy DTC’s eligibility requirements, DTC will impose a Global Lock on the issue. An officer of DTC who did not play any role in the determination regarding the Deposit Chill notice will review the issuer’s response and decide whether the response has satisfied DTC’s eligibility standards. Once the officer has made a decision: (i) if the decision is in favor of the issuer, DTC will not impose or will release the Global Lock, as the case may be; or (ii) if the decision is that the issuer’s response is not satisfactory, DTC will nevertheless not impose the Global Lock until DTC has given the issuer notice of the adverse decision and the opportunity to demonstrate that DTC’s determination was the result of DTC’s clerical mistake or a mistake arising from an oversight or omission in reviewing the issuer’s response. This added process will not constitute a substantive review. It will be limited to DTC making a determination whether, as the issuer has asserted, there was a clerical mistake or mistake arising from an oversight or omission. Absent such a showing, the Global Lock will be imposed.
Section 2(d) specifies the contents of the “record” in the event that the issuer appeals to the Commission from an adverse decision.
Section 3(a) provides that the issuer’s right to respond to the notice is dependent on compliance with the time periods specified for making submissions. Section 3(b)(i) reserves to DTC the right: (x) to lift a Deposit Chill, or (y) to impose a Deposit Chill after it has provided a Deposit Chill Notice but before it has received or resolved a Deposit Chill Response (including after any Additional Request when an Additional Response is pending) without waiting for the applicable notice periods to run, in either case, in order to prevent imminent harm, injury or other such consequences to DTC or its Participants or where DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through it, irrespective of whether Rule 22(A) provides specific grounds for doing so. Section 3(b)(ii) specifically provides that Rule 22(A) does not apply to processing interruptions based upon ordinary course operational requirements such as those in connection with corporate actions and reorganization events that may occur at the request of the issuer or its representatives, or other such processing interruptions specifically set forth in the Procedures.
Section 3(b)(iii) recognizes that Rule 22(A) shall not displace any legal or regulatory requirements that DTC is subject to under applicable law, rule or regulation. This could conceivably include imposing a Deposit Chill where required by applicable law, rule or regulation and for reasons that may not include large volume deposits of low value or thinly traded securities. If, however, DTC imposed a Deposit Chill under such circumstances, DTC would afford the affected issuer the fair procedures set forth in proposed Rule 22(A) (except if prohibited by law, rule or regulation). Section 3(b)(iv) emphasizes that while DTC may freely communicate with the issuer or its representative, substantive communications must be in writing in order to provide the Commission with a complete record in the event of an appeal.
Section 3(c) provides that in the event that the Corporation shall impose a Deposit Chill shall apply, including that the Corporation shall provide the Deposit Chill Response within ten (10) business days after the Corporation receives the Deposit Chill Response or the Additional Response. Section 3(d) sets forth the means by which DTC shall send notice to the issuer.
Proposed Rule 22(B)
Section 1 provides that Rule 22(B) sets forth the fair procedures available to issuers where DTC imposes a Global Lock with respect to an issuer’s Eligible Securities, in two situations. Section 1(a) refers to a Global Lock based upon an Enforcement Proceeding with respect to an issue of securities that DTC determines were deposited at DTC. Section 1(b) refers to a Global Lock where an issuer has failed to satisfy the requirements to object to the imposition of, or for lifting, a Deposit Chill pursuant to Rule 22(A).
Section 2(a) provides that issuers will be given twenty business days’ advance notice that DTC intends to impose a Global Lock or if DTC reasonably determines that it is faced with, among other things, imminent harm, injury or other such consequence to itself or its Participants, or where the Corporation otherwise reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through the Corporation, whether or not such circumstances are otherwise specified by Rule22(B), notice will be given within three business days after the Global Lock has been imposed. In addition to setting forth the contents of the notice, Section 2(a) sets forth the issuer’s right to contest the action by submitting a response to the notice and the time frame for doing so.
Pursuant to Section 2(b)(i), if the issuer is able to demonstrate that an error had been made in identifying its securities as the subject of the underlying Enforcement Proceeding, the Global Lock would not be imposed or, had it already been imposed without notice or at any time after the imposition of a Global Lock), it would be released. Pursuant to Section 2(b)(ii), if, at any time, the Enforcement Proceeding has been withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the Defendants allegedly responsible for the violations of Section 5 of the Securities Act relating to the Eligible Securities, the Global Lock would not be imposed or, had if it had already been imposed, it would be released. In reviewing the issuer’s response, DTC will not provide a forum for litigating or re-litigating the allegations or findings in the Enforcement Proceeding, provided, however, that the issuer’s response may include a demonstration that the allegations or findings in the Enforcement Proceeding have been rejected by a court or that the issuer can otherwise satisfy the criteria set forth in Section 3 of proposed Rule 22(B).
Section 2(c) sets forth the time frame in which DTC will provide the issuer with a written decision responsive to the Global Lock Response. Specifically, DTC will provide each issuer that submits a Global Lock Response with a written decision within twenty business days after DTC receives Global Lock Response or, in the case of a Global Lock imposed before issuance of the Global Lock Notice, within ten business days of its imposition.
Section 2(d) specifies the contents of the “record” in the event that the issuer appeals to the Commission from a determination by DTC. Section 3 provides for the release of Global Locks. In the case of Global Locks imposed pursuant to Section 1(a), the restriction will be lifted either six months or one year, as the case may be, after the Enforcement Proceeding has been withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the Defendants allegedly responsible for the violations of Section 5 of the Securities Act relating to the Eligible Securities. The six-month period applies to affected issuers that file periodic reports pursuant to Section 13(a) and 15(d) of the Exchange Act) and the one-year period applies to issuers that are not public reporting companies. In support of the foregoing: (i) the Issuer may be required to submit a legal opinion, in form and substance satisfactory to the Corporation, from independent securities counsel to the issuer, reasonably acceptable to the Corporation, and/or (ii) such other evidence or other documentation as the Corporation may reasonably require. Companies defined in Securities Act Rule 144(i)(1) are not entitled to take advantage of this procedure and the Global Lock will remain in effect for any shell company issuer, unless it complies, or has complied, with the requirements of Securities Act Rule 144(i)(2).
Section 5(b)(i) reserves to DTC the right: (x) to lift a Global Lock, or (y) to impose a Global Lock after DTC has provided a Global Lock Notice but before it has received or resolved a Global Lock Response without waiting for the applicable notice periods to run, in either case, in order to prevent imminent harm, injury or other such consequences to DTC or its Participants or where DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through it, irrespective of whether Rule 22(B) provides specific grounds for doing so. Section 5(b)(ii) specifically provides that Rule 22(B) does not apply to processing interruptions based upon ordinary course operational requirements such as those in connection with corporate actions and reorganization events that may occur at the request of the issuer or its representatives, or other such processing interruptions.
Section 5(b)(iii) recognizes that Rule 22(B) shall not displace any legal or regulatory requirements that DTC is subject to under applicable law, rule or regulation. This could conceivably include imposing a Global Lock where required by applicable law, rule or regulation and for reasons that may not include an Enforcement Proceeding. If, however, DTC imposed a Global Lock under such circumstances, DTC would afford the affected issuer the fair procedures set forth in proposed Rule 22(B) (except if prohibited by law, rule or regulation). Section 5(b)(iv) provides that while DTC may freely communicate with the issuer or its representative, substantive communications must be in writing in order to provide the Commission with a complete record in the event of an appeal.
Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule changes are consistent with the Act. Comments may be submitted by any of the the methods below. All submissions should refer to File Number SR-DTC-2013-11.
Electronic Comments:
Use the Commission’s Internet comment form ); or send an e-mail to [email protected].
Paper Comments:
Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090.
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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