On March 8th, 2019 SEC Chairman Jay Clayton and SEC Director of Division of Trading and Markets Brett Redfearn gave a talk at Fordham University. A transcript of their talk was posted online. While they touched multiple topics, their comments about penny stocks may herald significant changes. I quote their remarks and give my take below.
First is Jay Clayton addressing Rule 15c2-11 (emphasis mine):
A particular focus of mine is Rule 15c2-11. This rule was designed to ensure that broker-dealers have sufficient information to understand and evaluate securities that trade off-exchange, or “OTC”, prior to publishing a quotation and also be in a position to provide this information to investors. At the Roundtable, however, panelists noted circumstances where the current operation of this rule may result in retail investors having little or no relevant information about a company. I am concerned that these circumstances are an example of how uneven the information playing field can be for retail investors in this sector. I am particularly troubled by what I see — again said bluntly — as Rule 15c2-11 providing a significant exception to our disclosure rules for companies that (1) have not provided any recent information or (2) have conducted a reverse merger — e.g., a larger private company merging into a smaller or “shell” public company — and the post-merger company has no relevant public information available.
I have asked our Division of Trading and Markets staff to prepare promptly a recommendation to the Commission to update our rules to address these information issues, which experience tells us can be fertile ground for fraud and may be unnecessary to facilitate capital formation.
I also have a heightened level of concern for very low priced stocks known as penny stocks. These stocks, traded in the over-the-counter market, seem to have a special gravitational pull for fraudsters looking to take advantage of retail investors hoping for outsized returns. So I have also asked staff to review the sales practice requirements relating to penny stocks within Exchange Act Rule 15g-9 and the definition of “penny stock” within Exchange Act Rule 3a51-1. Again, I am sure that more can be done to help prevent fraud and manipulation in penny stocks.
The footnote  in the quote above is worth quoting in full as well:
See, e.g., Transcript of Roundtable on Regulatory Approaches to Combatting Retail Fraud (September 26, 2108), at 99 (Yvonne Huber, FINRA) (“I think under certain circumstances, piggyback eligibility should be taken away, such as in the reverse merger scenario, where there has been a completely different — a complete shift in the business line of a company, a complete change in ownership, a complete change in officers and directors. That’s essentially a new company and it probably doesn’t make sense in that space to allow piggybacking to continue.”), available at https://www.sec.gov/spotlight/equity-market-structure-roundtables/retail-fraud-round-roundtable-092618-transcript.pdf.
OTCMarkets has a good definition of the piggyback rule:
A “piggyback qualified” security is one that meets the frequency-of-quotation requirement described in SEC Rule 15c2-11(f)(3). The frequency-of-quotation test or “piggyback” exception is based on whether a broker/dealer has itself published quotations in the security in the applicable interdealer quotation system on at least 12 business days during the preceding 30 calendar days, with not more than four consecutive business days without quotations. Once this criteria has been satisfied, authorized participants may register on-line in a security. As long as the security remains piggyback qualified, any participant may quote the security without a Form 211 submission.
Basically, as long as one broker-dealer is posting quotations (making a market) in an OTC stock, all other brokers / market-makers can post quotes without having to file Form 211. The Form 211 is what is filed prior to the first broker making a market and requires a broker to essentially vouch for the company and the accuracy of its financials. Forcing companies to get a broker to vouch for them after doing a reverse merger would make it a lot harder for scammers running pump and dumps because they often will reverse-merge a private company into a public shell prior to a promotion. See Form 211 (pdf).
Below are SEC director Redfearn’s comments (emphasis mine):
First, following up on Rule 15c2-11, this Rule currently requires a broker-dealer, among other things, to review certain issuer information and have a reasonable basis for believing such information is accurate in all material respects and from a reliable source, before the broker-dealer initiates quotations for an OTC security.
The Rule, however, provides an exception from the information and review requirements for continuous quotations, known as the “piggyback exception.” Once a security becomes “piggyback eligible,” it can be quoted indefinitely in an interdealer quotation system without further review by any broker-dealer, provided there is not a break in quotations of more than four successive business days.
As Chairman Clayton noted, panelists at the Roundtable identified circumstances where the current operation of the piggyback exception may result in retail investors having little or no relevant information about a company. I anticipate that the Division of Trading and Markets staff will present a recommendation to the Commission to update Rule 15c2-11 in the near future.
Below are Director Redfearn’s comments regarding transfer agents (footnote omitted; emphasis mine):
Finally, another potential gap in current protection for retail investors relates to transfer agents. Transfer agents who provide services to issuers of restricted and control securities generally are responsible for processing requests from selling shareholders to remove restrictive legends in connection with the intended resale of these securities by their owners. If a transfer agent improperly or inappropriately removes a legend, it could facilitate an illegal public distribution of securities that could harm investors.
This is a topic that was discussed in the Commission’s 2015 Advance Notice of Proposed Rulemaking and Concept Release on Transfer Agents, and was also the subject of a panel discussion at last year’s Roundtable. At the Roundtable, panelists discussed their current practices with respect to the removal of restrictive legends, and noted that there was an absence of specific Commission rules that govern those practices. They also identified and discussed some potential regulatory responses to fill that gap. I anticipate that the Division of Trading and Markets staff will present a recommendation to the Commission to update the transfer agent rules, including considering a rule that would specify transfer agent obligations with respect to the tracking and removal of restrictive legends.
The focus by both Clayton and Redfearn on rule 15c2-11 is not surprising to me. I have highlighted this rule and Form 211 in previous blog posts on SEC enforcement actions against Delaney Equity Group and Spartan Securities Group. I belief that the comments by Clayton and Redfearn herald two distinct potential changes in rule 15c2-11:
- Companies that undergo a reverse merger will have to get a broker to file Form 211 to vouch for the accuracy of their financial statements
- Companies that cease to provide current financial information will have to get a broker to file Form 211 to maintain quoting eligibility (otherwise they would get moved to the grey market)
Judging from Director Redfearn’s comments, it is likely that the SEC will also tighten the rules on transfer agents removing restrictive legends from shares. This will create another point of friction making it harder for insiders running pump and dump scams to get their shares cleared to sell.
Update 9-26-2019: Added Brett Redfearn’s name to the first paragraph
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