SEC Amends Rule 15c2-11, Form 211 Amendments
On September 16, 2020, the Securities and Exchange Commission (the “SEC”) adopted amendments to Securities Exchange Act Rule 15c2-11. In early 2020, we wrote about amendments to Rule 15c2-11 that were proposed by the SEC in September 2019. The object of the proposed changes was, according to the regulator, to ensure that over-the-counter issuers—better known as penny stocks—would make “current information” available to prospective investors.
SEC Rule 15c2-11, last revised in 1991, provided that before quotations could be initiated for an OTC issuer, the issuer would need to find a sponsoring market maker who would, relying on “current information” provided by the company, compile and submit a Form 211 to the Financial Industry Regulatory Authority (“FINRA”). FINRA would process the form, and the stock could then begin to trade. For one month, it would only be quoted by the sponsoring market maker; subsequently, other market makers could “piggyback” on the Form 211 and publish their own quotes.
Over the past 30 years, the OTC Markets has changed enormously. Once it was an obscure corner of the larger equity marketplace. But with the dawn of the Internet age and the rise of online discount brokerages, information about penny stocks that in the past could only be obtained by telephoning a broker or by subscribing to the daily “Pink Sheets”—so called because they were printed on pink paper—became available to anyone who owned a computer hooked up to the Worldwide Web. At the same time, the heady bull market driven by skyrocketing dot.com companies brought millions of new investors to the markets generally. Vastly lower commissions charged by the discount brokers made frequent trading practical for people who fancied themselves “players,” and opened the penny market to the general public.
It also opened the door to increased fraud and securities manipulation. Penny stocks had never really been considered investment grade, precisely because of the lack of information available about most of them. There was a general expectation that those trading on FINRA’s OTCBB (“over-the-counter-bulletin-board”) platform should be SEC registrants that made periodic filings as required by the Securities Exchange Act of 1934 (the “Exchange Act”), but a great many did not do so. In 1999, the SEC demanded that all OTCBB companies meet the reporting requirements of the Act, or be booted to the lowly Pink Sheets. Perhaps the Commission believed its new rule would have a salutary effect on non-filers, and they’d rush to comply. If so, it was sadly disappointed. A great many issuers unable or unwilling to hire securities attorneys or auditors became Pink. The National Quotation Bureau, which published the Pink Sheets, had recently been purchased by a group of investors who eventually changed the name of their new enterprise to the OTC Markets Group. One of the first things they did was launch an electronic trading platform called Pink Link (now OTC Link). Pink Link was much faster than the OTCBB’s platform, which offered execution by telephone only. Better yet, it didn’t charge a fee to market makers. Within less than 15 years, the OTCBB was effectively dead, and OTC Link was the only game in town.
As the OTC Markets grew, it developed a variety of services for issuers. For a fee, they could post press releases and financial disclosures on its Disclosure and News Service. It tried to encourage transparency by creating a series of “tiers,” distinguishing companies that offered little or no information about themselves from those that made extensive disclosures as non-registrants, filed with the SEC, or produced audited financial statements without becoming SEC filers.
Despite these very fundamental changes to the OTC marketplace, Rule 15c2-11 never changed. The SEC saw a number of problems with that. One was burgeoning microcap fraud, or at least negligence. Of the stocks suspended by the agency’s Enforcement Division, nearly all were delinquent filers, outright scams, or companies that had been promoted in pump and dump operations. All that was in part made possible by Rule 15c2-11. Once a sponsoring market maker’s Form 211 for an issuer was processed by FINRA, and other market makers piggybacked on it, it might continue to trade with published quotations literally forever, even if the company itself had long since ceased to exist.
The Piggyback Exception
Part of what the SEC wanted its amended Rule 15c2-11 to address was the lack of current information for such issuers. It therefore proposed that broker-dealers—whether the original sponsoring market maker or those who’d piggybacked on his Form 211—be required to check periodically to ensure the information available to them about the company was still substantially accurate. The intention was not that market makers should contact the company; they’d be allowed to draw on disclosures provided by a qualified interdealer quotation system (“IDQS”). In practical terms, the IDQS would be OTC Markets Group, and the information would be that made available at its website by the issuers themselves.
When the proposed amendments were under discussion, but before they were published, some consideration was given to eliminating the piggyback exception entirely. Many market participants objected to that idea. It would have resulted in more work for market makers wishing to make a market in OTC stocks, and that work would have been uncompensated, because market makers are not permitted to charge fees for compiling Forms 211 and submitting them to FINRA. It would likely also have led to the delisting of many OTC issuers to the Grey Market, where they can trade, but published quotes cannot be offered.
When it drew up its final rule, the SEC was mindful of what Chairman Jay Clayton calls the three pillars of the agency’s mission: advancing investor protection, encouraging capital formation, and striving for market efficiency. While eliminating the piggyback exception would protect investors, it would do nothing for capital formation, and would negatively affect market efficiency.
In the end, it was decided to retain the exception, though not in in its original form. The variances to the proposed rule will make the greatest different to shell companies, and to what the SEC refers to as “catch-all” issuers: Pinks that are not SEC registrants, and so are not required to make any disclosure at all. Those companies will now be required to make some form of disclosure. A great many of them already do, in the form of materials posted on their own websites or, more usually, at the OTC Markets website. Commissioner Hester Pierce notes that the proposed rule has been modified to accommodate these issuers:
The amendments permit broker-dealers to publish a quotation if a publicly available balance sheet is dated within sixteen months of the published quotation, as in the proposal, and profit and loss and retained earnings statements are for the twelve months preceding the date of that balance sheet, rather than within six months of the quotation if the balance sheet is older than six months.
… The release also delays for two years the requirement that financial statements for the two preceding fiscal years be publicly available for catch-all issuers. This change from the proposal helps guard against the retroactive application of the rule; an issuer’s securities will not lose their quoted market due to a broker-dealer’s or qualified IDQS’s inability to obtain historical records that predated these amendments.
In the end, non-registrants will have to make limited disclosure, which is a welcome change. If they fail to meet the requirement, they’ll be delisted to the Grey Market or (see below) the “Expert Market.” If a qualified IDQS determines that an issuer’s current information is no longer current, broker-dealers will have a grace period of 15 calendar days in which they may continue to quote the stock. This will give investors an opportunity to exit their positions, should they wish to take it.
In addition, the final rule creates a new exception that permits broker-dealers to publish quotations without conducting an information review for the highly liquid securities of well-capitalized issuers. The Commission believes such issuers are less susceptible to fraud than other types of penny stocks.
Shell Companies
As part of its initiative to reduce fraud in the OTC market, the SEC originally proposed dealing harshly with shell companies. For decades, many private issuers have chosen to go public through mergers with dormant shells; in recent years that has become even more popular than before. Management of the private companies, itching to see their stock traded and eager to benefit from exposure that will make capital raises easier, believe these transactions will save them time and money.
In reality, though they may save time, they probably won’t save money. There are other problems as well. A “clean” shell can be expensive, costing in excess of $100,000. For an uncomplicated private company, starting from scratch, either as an SEC registrant or a “catch-all” issuer, is cheaper. A significant drawback is that while professional shell vendors assure clients that their products are indeed “clean,” often there are skeletons in the closet, in the form of control blocks held by former insiders, significant debt, and legal problems. Even worse, public shells aren’t always bought by individuals who intend to use them for honest purposes. Often they fall into the hands of fraudsters whose plans involve destructive pump and dump operations.
The SEC has long been concerned about fraud involving public shells. In an attempt to control it, in 2012 it introduced an enforcement program called Operation Shell Expel. Through 2016, each year large numbers of shells, mostly non-registrants, were subjected to trading suspensions and, once the suspensions expired, relegated to the Grey Market. In a 2014 speech about “All-Encompassing Enforcement,” then-Chairman Mary Jo White explained that these suspensions “not only […] stop trading in the company’s stock for ten days, but they also have the effect of preventing market makers from displaying quotes in those securities until the company updates its public disclosures.”
Enforcement measures could easily be directed at dormant shells, but they were exempt from regulation as shells. The SEC has for years defined shell companies as:
…any issuer, other than a business combination related shell company… or an asset-backed issuer… that has (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.
Unfortunately, that definition only applied to registrants; it did not apply to “catch-all” issuers. In the proposed rule, the SEC advanced a slightly altered definition that was adopted in the final rule. There was some objection from commenters who felt it would be “ambiguous and difficult to apply,” but the Commission insisted:
The definition of shell company that the Commission is adopting does not preclude a broker-dealer, qualified IDQS, or registered national securities association from determining that an entity is a shell company based on an observation that a company has identified itself as a shell company (or as not a shell company) or, alternatively, review of a company’s financial information, including asset composition, operational expenditures, and income-related metrics. The definition of shell company under the amended Rule is consistent with the requirements of other established and broadly used Commission rules to provide market participants flexibility in analyzing the particular facts and circumstances involving an issuer, such as the issuer’s financial information and information related to its operations.
The adoption of the definition should bring welcome clarity, but much depends on the practical use to which the SEC will put it. In the proposed rule, the agency announced it intended to prohibit market makers from relying of the piggyback exception for shells. As a result, those companies would soon have been relegated to the Greys, where promotional activities do little good because of the market’s illiquidity.
So draconian a measure provoked cries of outrage from critics. What about development-stage companies? They are, in fact, protected by the provisions of the JOBS Act, and moreover are likely to wish to make current information publicly available to potential investors.
The Commission was willing to compromise, and adopted a modified version of its original proposal:
Under the amended Rule, a broker-dealer may maintain a quoted market for the security of an issuer that the broker-dealer has a reasonable basis under the circumstances for believing is a shell company by relying on the piggyback exception during the 18-month period following the initial publication or submission of a priced bid or offer quotation for the security in an IDQS, assuming all other requirements of the piggyback exception are met. After such period ends, the broker-dealer may publish or submit a quotation for the issuer’s security if the broker-dealer complies with the information review requirement or relies on a publicly available determination of a qualified IDQS that the qualified IDQS complied with the information review requirement. Such compliance involves, among other things, the broker-dealer or qualified IDQS having a reasonable basis under the circumstances for believing that such issuer’s paragraph (b) information is accurate in all material respects and is from a reliable source. Thereafter, the broker-dealer may continue to publish or submit a quotation for the issuer’s security so long as either the broker-dealer continues to comply with the information review requirement or relies on a publicly available determination of a qualified IDQS that such qualified IDQS complied with the information review requirement. The Commission believes that compliance with the information review requirement is needed following the 18-month period to appropriately balance the facilitation of capital formation and the promotion of investor protection.
The modifications to the original proposal are disappointing. Penny stocks can be pumped and dumped three times or more in an 18-month period. While still concerned about fraud involving public shells on the one hand, on the other, the Commission is convinced that “reverse mergers are also an important tool for capital formation.”
The Expert Market
If the securities of an OTC issuer lose compliance with Rule 15c2-11, they’ll be delisted to the Grey Market. That occurs automatically if there are no published quotations for a stock for four consecutive trading sessions. (An additional requirement that the stock be quoted on at least 12 days within the previous 30 calendar days has been dropped in the final rule.) The Grey Market, sometimes called the “penny stock graveyard,” has historically been extremely illiquid. Many of its inhabitants eventually stop trading entirely, and their ticker symbols will be deleted by FINRA.
Stocks end up on the Greys for one of two reasons. Trading may have been suspended for 10 days by the SEC or halted by FINRA for more than four sessions; or they may simply have faded away, provoking so little interest in the investing public that their market makers decamped. According to a table based on data from FINRA and OTC Markets that accompanies the final rule, 63 percent follow OTC Markets’ alternative reporting standard; most of the others are, we imagine, delinquent SEC filers. Curiously, the SEC states flatly that “[t]hree percent of issuers with quoted OTC securities were shell companies, and broker-dealers were able to rely on the piggyback exception to publish or submit quotations for nearly all securities for shell companies (99 percent).”
But until the final rule was promulgated, the SEC’s definition of a “shell company” didn’t apply to non-registrants. It was left entirely to the issuers themselves to declare in their disclosure to OTC Markets whether they were shell companies or not. Moreover, if those companies have been Grey for years, they probably aren’t making any disclosure at all. The “three percent” statistic is useless. Adding to the irrelevance, the SEC adds in a footnote that OTC Markets states that as of December 2019, 339 issuers had self-reported as shells, and that it had flagged another 534 as “shell risks”, but doesn’t indicate how many of them trade on the Grey Market.
Probably most of the companies that trade on the Grey Market are shells that have been abandoned by management, or are still controlled by management but dormant. Why does their stock trade at all? The SEC periodically clears out registrants that are delinquent filers, suspending them and revoking their registration. If they want to reregister, they must file a new initial registration statement and thereafter comply with their reporting obligations under the Exchange Act. The story is different for non-registrants, which can continue to trade forever as “zombie tickers.” In an investor bulletin from 2013, the SEC says:
The SEC does not have a rule that prohibits the trading of stock once a company becomes defunct because it does not want to forbid transactions between willing buyers and sellers, including those holding shares in defunct companies.
This is, apparently, the kind of thinking that inspired OTC Markets to create its relatively new “Expert Market.” There’s no mention of the Expert Market in the SEC’s proposed amendments to Rule 15c2-11, but it’s referred to a number of times in the final rule. It’s noted in the rule that some commenters, including OTC Markets itself, had suggested that securities of dark companies should be allowed to be quoted in a market where quote distribution would be limited to “professional investors” and a few others. The SEC considered those suggestions, and decided:
The Commission believes that, under certain conditions and circumstances, it could be beneficial to establish an “expert market” that would enhance liquidity for sophisticated or professional investors in grey market securities, as well as for small companies seeking growth opportunities that might prefer to be quoted in a market limited to such persons. To facilitate the formation and implementation of such a market, the Commission has the authority to issue exemptive relief by order pursuant to Section 36 of the Exchange Act and paragraph (g) of the amended Rule that is necessary or appropriate in the public interest, and is consistent with the protection of investors. In this regard, the Commission may consider, among other things, the types of investors who could access quotations in this market and the types of securities that would be quoted in such a market.
As it happened, when the SEC wrote that, the OTC Market Group’s “Expert Market” had already been in existence for more than a year. The Expert Market tier was added to OTC Link on April 23, 2019, though most interested observers didn’t become aware of it until late in the same year. OTC Markets described it in its glossary as “a private market to serve broker-dealer pricing and best execution needs in securities that are restricted from public quoting or trading. Restrictions can be based on issuer requirements, security attributes, investor accreditation and/or suitability risks.”
That initially created some puzzlement among penny players, though eventually most realized that despite a name suggesting “expertise,” this new market was essentially the Grey Market with electronic trade execution. In fact, in most of the SEC’s references to it in the final rule, that is how it’s treated: as the “Grey or Expert Market.” That is strange, as the Commission also says:
In considering any such exemptive relief, the Commission preliminarily believes that any such expert market must not have the potential to develop into a parallel market for which quotations are accessible by retail investors and the general public. To protect retail investors from the harms resulting from incidents of fraud and manipulation in OTC securities for which no or limited publicly available information about the issuers exists to help counteract misinformation, such exemptive relief could focus on the types of investors that have the ability to assess an investment opportunity, including the ability to analyze the risks and rewards.
And yet the Expert Market, by now well established at OTC Markets, features stocks that can be traded by anyone with a brokerage account. Like Grey Market issues, they aren’t quoted, but interested buyers and sellers can follow the tape to get an idea what orders are likely to be accepted. Thanks to electronic trade execution, Expert Market stocks are generally considerably more liquid than Grey stocks. It’s unclear how many securities by now trade on the Expert Market, but the number is well into the hundreds at least. Included among them are quite a few stocks that were recently subjected to trading suspensions, are also quoted on an unsolicited basis, and have been assigned OTC Markets’ Caveat Emptor investor warning as well.
The Future
The SEC seems oddly and uncharacteristically uncertain about how the new Rule 15c2-11 will work out for the parties involved. In closing, it points out that some issuers may find they’ll need to make disclosure more often than they’d like. Broker-dealers may be required to review issuers’ information more often than they’d like, causing them to withdraw from quoted OTC markets. All that could cause investors in the OTC to lose heart, and lose money, thanks to increased trading costs and decreased liquidity. Nonetheless, “[t]he Commission believes the amended Rule is better than the alternative because the additional benefits from more frequently available information are likely to be relatively minor, while the costs for issuers, broker-dealers, and other market participants could increase in proportion to the required frequency of making current information publicly available.”
Although the SEC has officially adopted its amendments to Rule 15c2-11, Commissioner Pierce notes in her statement that the Commission has established a “nine-month transition period, which should provide sufficient time to avoid unnecessary disruption in the quoted market for OTC securities that might otherwise fall into the grey market under these rules,” adding that those nine months will pass quickly, and encouraging broker-dealers, investors, IDQSs, and issuers, as appropriate, to engage with staff about any problems they may foresee.
For further information about this securities law blog post and Form 211, 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 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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